Q: We recently retired and our financial advisor is very positive about us putting some of our savings into a segregated fund because it guarantees at least a 3% annual return and a full return of capital within 10 years.
We like the security, but we are concerned about losing the ability to invest this money in ETFs for 10 years, even with the risk that markets may correct for a period of time.
—Andy
AND: I have a general rule about warranties and it is that buyers should beware, Andy. When someone offers you a guarantee, it is usually in their best interest, not yours. For example, extended warranties are priced to be profitable for the offeror, not to give you an advantage as a consumer.
Segregated funds mirror the insurance industry in mutual funds. They generally have a basic guarantee of 75% or 100% of your capital after 10 years or in the event of your death.
In the case of a separate fund with a 10-year guarantee, the main reason for the distortion of the offer in favor of the issuer is that 10-year periods of declines on the stock exchanges are few. In fact, since 1900, the only two short-term periods in which the S&P 500 Index was negative within 10 years were the periods ending in the late 1930s after the Great Depression and the periods ending in 2009 during the lows of the subprime mortgage crisis . So 99% of the time, 10-year returns have been positive for US stocks.
In Canadian stock markets, since 1960, the TSX has returned over 6% over 10 years more than 90% of the time. At no point in the last 10 years have TSX returns been negative.
What about that 3% back guarantee? Andy, the TSX has returned over 3% in over 99% of 10-year periods since 1960.
Apart from the basic guarantee, one thing that is also guaranteed in segregated funds is high fees. Segment fund fees are typically higher than typical Canadian mutual funds, which start out high as a group. If you give up 3% of your investment return in fees every year, you’re almost guaranteeing that you’ll lag behind the potential performance of your ETF portfolio – not to mention most mutual fund returns.
Ask a planner: Leave your question with Jason Heath »
While there are good active managers who outperform their benchmarks over time, I’m afraid you’re unlikely to find them managing a portfolio of insurance company segregated funds. Few managers can overcome the 3% fee hurdle that most segregated funds face.
The thing is, Andy, the 10-year warranty is virtually worthless given the stock’s history. This may sound good to the consumer, but stocks generally don’t decline over a 10-year period. A balanced portfolio of stocks and bonds will likely exceed the promised 3%.
One thing investors should be aware of regarding segregated funds is that mutual funds are subject to new fee disclosure regulations that come into effect next July. Distributed funds are exempt. For some reason, the insurance industry has not yet committed to disclosing fees in the same way that the investment industry committed in 2016. This breakdown may be more attractive to advisors because they won’t have to disclose how much they earn to put you on them.
And I don’t want to be pessimistic, but a segregated fund will probably pay your advisor 1% per year for the next 10 years. If they are not licensed to sell ETFs, they may not be able to offer them to you. I hope he told you that instead of just arguing why segregated funds are better.
And if he is licensed to sell index funds – the mutual fund industry’s equivalent of an ETF – his own 10-year return in the form of an entry fee from the fund company will likely be lower than the segregated fund would pay him. So it may be that recommending a seg fund is in the best interests of your financial advisor’s retirement, not yours.
Ask a planner: Leave your question with Jason Heath »
Jason Heath is an advisory-only certified financial planner (CFP) at Objective Financial Partners Inc. in Toronto. It does not sell any financial products at all.
Want even more tips on how to get your finances in order? Join Money Fit Club to cut expenses, increase your earnings, reduce taxes and more!
Learn to strengthen your financial muscles all year round with our interactive calendar and sign up to receive our weekly advice newsletter straight to your inbox.
