Q: : My wife will be 56 this year and she has about $150,000 invested with a financial advisor who wants to move it all into segregated funds. He expects to work for another six to 10 years. I’ve looked at the performance and costs (in terms of fees and penalties) of the seg funds I want to recommend, and unless there’s a major market crash, I don’t see the point in making such a move. I have read rumors of a serious crisis that may occur in the next few years. But more than 25% of the market? any ideas? I’m afraid she’s just looking for a commission or is really trying to act in her best interest.
—Morgana
AND: I share your concerns Morgan and this may mean taking a commission. I’ve seen this before and here’s how it works:
If your original investment was placed in a deferred sales charge (DSC) fund and is now fee-free, most advisors cannot reinvest the money back into the DSC fund and charge a large upfront commission a second time. However, insurance products are regulated by a different entity, so advisors can reinvest your money back into the DSC segmented fund, receive an upfront commission and lock you in for another seven years.
Related: Segregated Funds: Are Investment Guarantees Worth It?
Additionally, advisors are not required to report seg fund fees the same way they do mutual fund fees. Switching to segments is a way for your advisor to avoid a potentially uncomfortable conversation about fees.
Enough of the negatives, here are three benefits of segmented funds.
- Creditor protection – although you will get this under RRSPs and TFSAs if there is a designated beneficiary. So this benefit actually applies to unregistered accounts.
- Skip probate and avoid paying inheritance tax on the transfer of assets – although if there is a designated beneficiary on the RRSP and TFSA, you avoid inheritance tax. Again, this is beneficial for unregistered accounts rather than RRSP or TFSA investments.
Related: Pros and cons of segregated funds
How much is inheritance tax and how much does the seg fund additionally cost? In Ontario, the inheritance tax on $150,000 is $1,750. How much do you pay for an estate bypass benefit? A segmented fund’s management expense ratio (MER) is typically about 0.5% higher than the underlying mutual fund. So Morgan, is it worth paying an extra $750 a year ($150,000 x 0.5%) to save $1,750 in inheritance taxes?
- 100% death benefit guarantee and 75% investment guarantee (the most popular 100/75).
If you die and the value of your investment is less than the original value, the insurer will equalize your investment, i.e. if $150,000 falls to $100,000 at the time of your wife’s death, the insurer will restore the balance to $150,000.
Fortunately, most people are unaware of this benefit, but the odd person will. This is insurance. Do you want insurance coverage for this unlikely event?
Related: Are Seg Funds Worth the Premium?
Did you know that $615 a year will pay your wife $250,000 for 10 years term insurance?
Please note that reset functions are often available with a segmented fund. So if you invest $150,000 and three years later the value of the seg fund is $160,000, you can reset the death benefit guarantee to $160,000. (Note: Each company that issues seg funds has its own characteristics.)
What about the 75% investment guarantee? If after 10 years your original investment declines by 25% or more, the insurer will restore your investment account to 75% of its original value.
Related: Segregated Funds: A Broken Nest Egg
I looked at the market returns of the S&P 500 Index since 1926 and found only three 10-year periods of negative returns – 1929, 1930 and 2000, with the largest loss being 0.9% before fees. If you add 2.5% or more MER to the equation and/or an active fund manager getting it wrong, after 10 years you could be down 25% or more if you invested in those years.
There are cases where a seg fund might make sense, but I think most people can do without it. In my opinion, you would be better off taking the $750 cost of a segmentation fund and translating it into a financial/real estate plan that addresses the problems the segmentation fund is trying to solve, but I am a biased financial planner.
Allan Norman, M.A., CFP, CIM, Atlantis Financial/IPC Investment Corp.
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