Ep # 92 - Paying for Promises: An Evidence-Based Look at Segregated Funds with Mark McGrath
Joe speaks with Mark McGrath (CFP, CIM, CLU, PWL Capital Inc) about the intricacies of Canadian equity segregated funds, unpacking their features, benefits, and potential drawbacks.
While discussing the investment options within segregated funds, they underscore the importance of considering alternatives like low-cost index funds or ETFs, particularly for investors seeking to optimize returns while minimizing fees.
This episode equips listeners with valuable knowledge to make informed financial decisions tailored to their needs by providing insights into the nuances of segregated funds and alternative investment strategies.
What You’ll Learn in Today’s Episode
Complexity of Segregated Fund Contracts: The discussion emphasizes the multifaceted nature of segregated fund contracts, involving four distinct parties: the owner, annuitant, beneficiary, and the insurance company.
Limited Investment Options: While segregated funds offer a range of investment options similar to mutual funds, including asset allocation funds, stocks, bonds, and money market funds, there's a notable lack of evidence-based or index fund options.
High Fees and Performance Predictors: The episode highlights the significant impact of fees on segregated funds, with average fees ranging from 2.92% to 3.27% annually. Moreover, it underscores the correlation between high fees and underperformance, emphasizing the importance of fee-conscious investing.
Consideration of Alternatives: Despite the marketed benefits of segregated funds, the hosts advocate for exploring alternatives such as low-cost index funds or ETFs. These alternatives offer similar benefits, such as creditor protection and beneficiary designation, at potentially lower costs, making them more suitable for many investors.
Individualized Decision-Making: Ultimately, the episode emphasizes the need for investors to assess their unique circumstances and goals when considering segregated funds or alternatives. By understanding the costs, benefits, and available options, investors can make informed decisions aligned with their financial objectives.
Ideas Worth Sharing
· "What makes segregated funds unique is that they are actually life insurance policies that invest in underlying assets, which are usually mutual funds. However, they do come with a set of guarantees that a mutual fund doesn't have."
· "It's very complex, and the complexity is because there are four different parties to the contract."
· "There is no evidence-based investing options in segregated funds."
· "Where the market risk comes in is, if you're going to invest in a segregated fund contract, then you're going to be paying 3% for a contract that has a basket of mutual funds that might cost you 1%, 1.5%.
· "You're really paying that fee for that insurance guarantee, and if you don't need the insurance guarantee, there's no reason to pay that extra fee."
Resources in this episode
Segregated Funds Deep Dive: Navigating the Complexities
Have you heard these ideas about segregated funds?
Idea 1: Segregated funds are too expensive.
Idea 2: Segregated funds have low transparency.
Idea 3: Segregated funds are the only option for guarantees.
“I'd say get a second opinion from somebody who, assuming you've purchased this from somebody who's an insurance advisor, only get a second opinion from somebody who can use alternatives.” - Mark McGrath
Segregated funds represent a unique intersection of investment and insurance products, offering a blend of mutual fund-like returns and insurance guarantees. Understanding the intricacies of segregated funds is crucial for anyone considering investing in them. This deep dive will explore the features, benefits, and costs associated with segregated funds, helping investors navigate their complexities.
What are Segregated Funds?
Segregated funds, known as seg funds, are life insurance policies that invest in underlying assets, typically mutual funds. These funds come with guarantees not found in mutual funds, providing a distinct advantage for risk-averse investors. The most notable feature of segregated funds is the insurance guarantee, which ensures a return of a percentage of the investor's principal upon maturity or death. This safety net can be particularly appealing for those concerned about market volatility and potential significant losses.
Key Features and Parties Involved
The complexity of segregated funds stems from the involvement of multiple parties and the structure of the contracts. Each segregated fund contract typically involves four parties: the investor, the insurance company, the fund manager, and the beneficiary. The investor purchases the segregated fund, the insurance company issues the contract, the fund manager handles the investments, and the beneficiary receives the proceeds in the event of the investor’s death.
One of the primary reasons for the higher costs associated with segregated funds is the insurance guarantee. Unlike mutual funds, which do not offer principal protection, segregated funds promise to return a portion of the invested capital at the end of the term or upon the policyholder's death. This guarantee can provide peace of mind but comes at a price.
Costs and Returns
Segregated funds tend to be more expensive than mutual funds due to the additional layer of insurance protection. The average management expense ratio (MER) for segregated funds ranges from 2.92% to 3.27%. This is significantly higher than the MERs for many mutual funds, which typically range from 1% to 1.5%. Investors are essentially paying for the insurance guarantee that segregated funds provide. If investors do not require this guarantee, they might be better served by traditional mutual funds, which can offer similar investment returns at a lower cost.
It's important to note that segregated funds do not typically include evidence-based investing options. This means they may not align with the principles of evidence-based investment strategies, which rely on empirical data and rigorous analysis to guide investment decisions. Investors seeking such strategies might find segregated funds less appealing.
Evaluating the Need for Segregated Funds
When considering whether to invest in segregated funds, investors should carefully evaluate their need for the insurance guarantees offered. These guarantees can benefit those with low-risk tolerance or individuals who want to ensure a portion of their investment is protected for their beneficiaries. However, if the insurance aspect is unnecessary, the higher fees associated with segregated funds may not be justified.
In this episode, you will be able to:
Discover the benefits of segregated funds for retirement planning and wealth protection.
Explore diverse investment options in segregated funds tailored to your retirement goals.
Uncover alternative investment choices that rival segregated funds for retirement security.
Learn how fees impact your segregated fund investments and how to mitigate their effects.
Understand the creditor protection advantages offered by segregated funds for your retirement.
The resources mentioned in this episode are:
Contact Mark McGrath at M.mcgrath@wlcapital.com for financial planning and portfolio management services.
Connect with Mark McGrath, CFP, on Twitter and LinkedIn for valuable financial insights and advice.
Reach out to a fee-only planner or hourly planner for a second opinion on your investment portfolio, especially if you currently hold SEG funds.
Consider alternatives to SEG funds, such as low-cost, globally diversified index funds suited to your risk tolerance.
Revisit the entire reason for owning SEG funds with your advisor and ensure a thorough understanding of the product's complexities and fees.
Timestamped summary of this episode:
00:00:01 - Introduction and Segregated Funds Overview
Joe introduces Mark and discusses the growing popularity of segregated funds in the investment industry. Mark provides an overview of segregated funds, comparing them to a combination of mutual funds and insurance policies.
00:02:15 - Segregated Funds Industry Size
Mark discusses the size of the segregated funds industry, mentioning that it managed about $130 billion in assets and is growing over time. He also highlights the potential reasons for this growth, including the lack of transparency and the sales force's influence.
00:05:47 - Guarantees in Segregated Funds
Mark explains the two types of guarantees in segregated funds: maturity guarantee and death benefit guarantee. He discusses the percentage and time horizon associated with these guarantees, as well as the implications of higher guarantees on the fund's cost.
00:08:31 - Reset Feature and Its Implications
Mark delves into the reset feature in segregated funds, emphasizing its impact on the maturity guarantee's time horizon. He also provides insights into the probability of utilizing a maturity guarantee over a long period and the implications of underlying asset classes' performance.
00:10:40 - Probability of Guarantee Payout
Mark discusses the historical probability of segregated fund contracts paying out based on the performance of the Canadian stock market index. He also addresses the likelihood of the death benefit guarantee paying out within a six-month period, considering the fund's performance and fees.
00:12:49 - Segregated Fund Performance and Fees
The conversation delves into the impact of fees on segregated fund performance, examining the probability of underperformance and the need for protection due to high fees.
00:13:32 - Probability of Payout and Underperformance
The discussion explores the increased probability of payout due to underperformance caused by high fees, leading to the need for protection and the circular reasoning behind it.
00:14:51 - Named Beneficiaries and Estate Bypass
The benefits of naming beneficiaries in a segregated fund contract are discussed, highlighting the bypassing of the estate and potential savings on probate fees, while also considering the additional cost involved.
00:17:55 - Creditor Protection and Insolvency Rates
The conversation turns to the creditor protection offered by segregated funds, analyzing the insolvency rates in Canada and the low probability of creditor claims, leading to a consideration of the cost-effectiveness of this feature.
00:22:41 - Niche Scenarios for Segregated Funds
The discussion explores specific scenarios where segregated funds may be considered, such as for small business owners seeking creditor protection or individuals aiming to qualify for provincial disability benefits while protecting their assets.
00:26:03 - Understanding Segregated Funds
Mark explains the roles of the owner, annuitant, and beneficiary in a segregated fund contract. He compares it to a family trust and discusses the complexity of naming successors.
00:28:04 - Investment Options in Segregated Funds
Mark discusses the variety of underlying asset classes available in segregated funds, including asset allocation funds, small cap US stocks, bonds, and money market funds. He also touches on the presence of index funds and actively managed ETFs in segregated funds.
00:30:23 - Fees and Comparisons
Mark delves into the average fees for segregated funds in Canada, comparing them to index funds. He emphasizes the impact of fees on investment performance and challenges the comparison between segregated fund fees and equivalent mutual fund fees.
00:33:48 - The Impact of Fees and Turnover
Mark discusses the impact of fees and turnover on fund performance, highlighting the potential underperformance of actively managed funds. He emphasizes the importance of low-cost, globally diversified index funds as an alternative to segregated funds.
00:37:11 - Alternatives to Segregated Funds
Mark suggests alternatives to segregated funds, such as using trusts for creditor protection and estate planning, gifting money while alive, and considering permanent insurance based on individual health and goals. He emphasizes the need to evaluate cost-effective options for specific financial goals.
00:38:04 - Liability protection and alternatives to segregated fund contracts
Mark discusses the liability protection offered by incorporating a business and the benefits of having a holding company. He also highlights the alternatives to segregated fund contracts, such as annuities and index funds.
00:38:30 - Final thoughts and Assurus protection
Mark explains the protection offered by Assurus for insurance products and compares it to the protection provided by the Canadian Investment Protection Fund. He emphasizes the importance of understanding the fees and guarantees associated with segregated fund contracts.
00:39:46 - Second opinion and understanding the products
Mark recommends getting a second opinion from an advisor who can provide alternative options. He stresses the complexity of segregated fund contracts and advises investors to ensure that both they and their advisor fully understand the products.
00:40:43 - Action items for SEG fund portfolio holders
Mark suggests taking a close look at the fees and guarantees of segregated fund contracts, discussing the reasons for owning them with the advisor, and seeking a second opinion from a neutral advisor. He encourages investors to be educated about the complexities of these products.
00:41:41 - Mark's expertise and contact information
Mark shares that his expertise goes beyond segregated fund contracts and mentions being a financial planner and associate portfolio manager for PWL Capital. He provides his contact information for those who would like to reach out to him for further discussions.
Frequently Asked Questions
-
In Episode 90 of our podcast, we discussed the Segregated Funds Industry Size, which refers to the total value of assets managed within segregated funds. Currently, it stands at approximately $130 billion, showcasing significant growth and popularity among investors. Factors such as unique features and benefits, along with sales force influence, contribute to this expansion.
-
Segregated funds offer a range of investment options tailored to retirement goals, including asset allocation funds, small-cap US stocks, bonds, and money market funds. These diverse options allow investors to customize their portfolios based on their risk tolerance, time horizon, and financial objectives. Retirement planning is a crucial aspect of segregated fund investment, and these funds provide strategies specifically designed to meet retirees’ income needs and capital preservation goals during retirement. Whether retirees prioritize generating income, preserving capital, or achieving growth, segregated funds offer flexibility and versatility to align with their retirement planning strategies.
-
Mark provides insights into the diverse underlying asset classes within segregated funds, including asset allocation funds, stocks, bonds, and money market funds, while addressing the presence of index funds and actively managed ETFs.
-
Retirees can tailor their segregated fund investments with the guidance of a retirement advisor, selecting funds aligned with their retirement goals and risk tolerance. Whether prioritizing income generation, capital growth, or a balanced approach, retirees can diversify their segregated fund holdings to create a portfolio that reflects their desired outcomes.