Segregated Funds vs. Mutual Funds: A Comprehensive Comparison
When it comes to investing, understanding the products available can help you make informed decisions tailored to your financial goals and risk tolerance. Two common investment vehicles in Canada are segregated funds and mutual funds. Both allow investors to pool money for professional management, but they differ in structure, purpose, and benefits. This blog will compare mutual funds to segregated funds, discussing how they work, their pros and cons, and the types of investors they best suit.
What Are Segregated Funds?
A segregated fund, often referred to as a “seg fund,” is an investment product offered by insurance companies. They combine features generally only available through either insurance or investment products. Like mutual funds, seg funds pool investors’ money to invest in a diversified portfolio of assets such as stocks or bonds. However, they also come with insurance guarantees and other protections.
Key Features of Segregated Funds
1. Insurance Guarantees
Seg funds come with maturity and death benefit guarantees, typically ranging from 75% to 100% of the initial investment. This means that even if the market underperforms, you’re guaranteed to receive at least a portion of your invested capital at maturity or upon death.
Here is an example. Betty invests $100,000 into a seg fund with a guarantee structure of 75% maturity and 100% death. In two years, Betty needs to make a withdrawal of her entire portfolio, but the markets are currently down from when she originally invested. By owning this seg fund she would be guaranteed a withdrawal of $75,000 (if her account was worth $60,000 at market rates, she would receive $75,000. If her account was worth $90,000 she would receive the $90,000). If at any point Betty were to pass away her beneficiary would receive a minimum of $100,000. If her account was worth more than $100,000, say $120,000, her beneficiary would receive $120,000.
2. Creditor Protection
Because they are considered insurance products, segregated funds may offer creditor protection if a beneficiary is named, making them a popular choice for business owners or professionals who have debt and value the creditor protection.
3. Estate Planning Benefits
Seg funds allow investors to bypass probate by directly designating beneficiaries, ensuring quicker distribution of funds and lower estate settlement costs.
4. Higher Fees
Due to their insurance component, segregated funds generally have higher fees than other types of investments like mutual funds or ETFs.
What Are Mutual Funds?
Mutual funds are pooled investment vehicles managed by professional portfolio managers. They invest in a mix of securities depending on the fund’s objective, such as growth, income, or capital preservation. Mutual Funds offer no guarantees or other insurance benefits but are simply investment vehicles.
Key Features of Mutual Funds
1. Diverse Options
Mutual funds come in various types, including equity funds, bond funds, balanced funds, and index funds, catering to a wide range of investor goals and risk tolerances.
2. Liquidity
Mutual funds are highly liquid, allowing investors to buy or redeem units on any business day.
3. Lower Fees
Compared to segregated funds, mutual funds generally have lower Management Expense Ratios (MERs). These are fees associated with the fund which lower the total return to the investor.
4. No Guarantees
Mutual funds do not offer capital guarantees. Their value fluctuates based on market performance, and investors bear the full risk of losses.
Pros and Cons of Segregated Funds
Pros
Capital guarantees on maturity and/or death.
Easier to achieve creditor protection.
Estate planning benefits like bypassing probate and guaranteed value on death.
Cons
Higher management fees due to insurance features.
Fewer options for investment.
Early withdrawal penalties in some cases.
Pros and Cons of Mutual Funds
Pros
Wide range of investment choices.
Lower fees, compared to seg funds.
High liquidity and ease of access.
Cons
No guarantees; investors bear full market risk.
Potentially subject to probate (depending on account held within), delaying distribution.
Less options to achieve creditor protection.
Which Should You Choose?
Seg funds are popular mainly for estate planning purposes. The guarantees that are built in allow for an element of predictability that is useful when looking at an estate and planning for the transfer of wealth. Investors who use seg funds in their estate plans generally want to ensure a minimum amount of money is transferred to beneficiaries, charity or even their estate to handle things like final tax returns. Another potential reason for the use of seg funds is for people who may have a lot of liability and would value creditor protection.
For the investor who is more concentrated on long term growth or using the funds for themselves, such as in retirement, mutual funds are generally better suited to meet that need. This essentially comes down to the fee charged. If the investor does not need the creditor protection and is not yet worried about preserving the value of their estate, the additional fees charged on seg funds limit the growth of the account.
This does not mean mutual funds are the best/only option. While the fees are generally lower compared to segregated funds, they can still form a significant amount. Ensure you and your advisor examine and discuss all options to find what best suits your needs.
Conclusion
Both segregated funds and mutual funds have their merits and each will fill a certain need. However, since seg funds are technically an insurance product, advisors do not need an investment licence to use them. Therefore, ensure that if you are recommended a seg fund it is for the right reasons and not simply because it is the only investment type product an advisor can offer.
If you want more infomration on investment options, visit my previous blog post on mutual funds versus ETFs here: https://www.mcwealth.ca/blog/mutualfundsvsetfs