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Seg funds cut the risk -- but at what price?

For middle-class investors, the costs often outweigh the benefit of guaranteed returns

What they don't tell you about seg funds

Segregated funds are one of the most expensive investment products you can buy, making they a luxury many investors can't afford - and probably don't need. A hot product in the 1990s, these insurance-backed funds have seen their popularity tumble. Some well-known fund management firms have abandoned seg funds altogether.

The cost of owning segregated funds has escalated so quickly since the late 1990s that they have become a luxury many investors can't afford.

In fact, they have become so pricey that some well-known fund management firms -- including AIM Funds Management Inc. and Franklin Templeton Investments Corp. -- have exited the seg fund business because of weak investor demand, a function of a lengthy bear market and a regulatory decision by Ottawa that made them one of the most expensive investment products money can buy.

Seg funds, which are like mutual funds with insurance guarantees, don't draw much attention any more from financial advisers or the press. But they have quietly attracted almost $50-billion in Canadian investors' money, much of that invested during the late years of the bull run that ended with a thump in 2000.

For the insurance companies and mutual fund managers who run them, seg funds represent a lucrative piece of business. But for investors, there's a cost for peace of mind -- and in the case of seg funds, it has become so high that they probably aren't worth the money for most middle-class Canadians with fairly simple investment needs.

Most seg funds come with two forms of guarantees. One is a death benefit, so if you die within 10 years of putting your money in, your heirs will get some or all of it back. The other is a maturity guarantee: If you hold your money in the fund for 10 years and the portfolio goes down, you get at least a partial refund.

Seg funds were pretty well the exclusive domain of insurance companies until the late 1990s, when, spurred by the equity boom, mutual fund companies jumped into the seg fund game. Mackenzie Financial Corp., AIC Ltd., CI Fund Management Inc. and others joined the party.

Manulife Financial Corp. added some sex appeal by offering a 100-per-cent guarantee on other firms' popular mutual funds, and invented a new name -- guaranteed investment funds -- to describe an old idea.

For a while, seg funds were raking in new money. Net sales hit about $6-billion in 2000. That's when regulators started to get a little nervous.

With the markets so volatile and money pouring in, the Office of the Superintendent of Financial Institutions (OSFI) sought some assurance that insurers -- which ultimately underwrite the guarantees -- could, in fact, afford the seg fund guarantees in the case of a prolonged downturn in equities.

The federal agency, which regulates banks and life insurers, was worried enough by what it found that it imposed new rules on seg funds. In simple terms, insurance companies were forced to earmark capital to cover the guarantees.

That changed the economics of seg funds in a radical way. Costs went up: The average seg fund charged 2.96 per cent in management fees and expenses last year, up from 2.32 per cent in 1998, according to figures compiled by Morningstar Inc.'s Canadian unit. That's a 27-per-cent increase, much greater than the rise in costs for non-segregated mutual funds in the period, and it was too much for some of the biggest players in the fund industry.

"After a while, it began to make less sense for us in our business to be able to operate them because the appeal of seg funds -- just because costs went up so quickly -- declined for our marketplace," said Dwayne Dreger, a spokesman for AIM, Canada's fourth-largest mutual fund company. "They just became prohibitively expensive."

By Morningstar's numbers, seg funds are now about 20 per cent more expensive than the plain-vanilla mutual funds they mimic.

So is the guarantee worth the extra cost? That depends on whether you think stocks will drop over a 10-year period. History suggests the odds are low. Just 36 of the 725 funds in's database with track records of that length lost money in the 10 years that ended May 31, 2004.

The last 10 years might not be the best indicator, since it included both a historic bull run and a wicked correction. If you bought a Nasdaq index fund just as the tech bull was petering out in early 2000, you might well wish you had bought the seg fund version. But for more conservative funds, chances are the guarantee will turn out to be wasted money.

Fortunately, someone has done the research on exactly how much the insurance part of a seg fund should cost. Moshe Milevsky, a finance professor at York University's Schulich School of Business, crunched the numbers using statistical models developed for options and determined that a fair price for a 10-year guarantee on an equity growth fund is an extra 0.45 percentage points in fees, or $45 a year on a $10,000 investment. Any more and you're probably getting ripped off; any less and you're getting a good deal.

For funds that hold bonds, the guarantee is worth a lot less, naturally, since the odds that a portfolio of bonds will lose money over 10 years is much lower than for stocks. An investor should pay no more than $13 extra per year on that $10,000 investment for a balanced fund, Mr. Milevsky says, and just $2 (or 0.02 percentage points) for a pure bond fund.

By his measures, many Canadian investors are paying much more than they should. Take the AIC Advantage Segregated Fund II, a guaranteed version of the popular mutual fund of the same name. The fund's holdings are exactly the same, but with a 100-per-cent guarantee, the cost rises to 5.79 per cent from 2.69 per cent. That extra bit of security costs more than $310 a year on $10,000, almost seven times Mr. Milevsky's "fair value."

The average Canadian equity seg fund costs 0.66 percentage points more than the average Canadian equity mutual fund, or $66 on a $10,000 investment, according to Morningstar.

What's even more perplexing is the gap on some bond seg funds, like Manulife's seg fund version of AGF's Canadian Bond Fund, which is 38 per cent more expensive than the identical mutual fund -- an extra 0.75 percentage points a year for a guarantee that you will probably never need.

That is hardly unusual. Morningstar says segregated Canadian bond funds, on average, charge 2.31 per cent -- 0.75 percentage points higher than their non-segregated cousins, just like the Manulife fund. And that perplexes some industry watchers. "I would be particularly wary of high MERs [management expense ratios] on the fixed-income side of the equation," said Scott Mackenzie, president and CEO of Morningstar Canada.

How can insurance and fund companies get away with charging so much more than the mathematical fair value of the guarantees?

"Part of it is because they can," Mr. Milevsky says. "The more opaque the product, the easier it is to charge more than it's worth." The average Canadian has a difficult time calculating the fair price of an insurance product; the challenge is even greater when the cost of the insurance is buried into one larger number: the MER.

Still, Mr. Mackenzie says, "there are a lot of perfectly legitimate reasons why costs would go up." The OSFI rules are only part of it. GST was added to the calculation of fund expense ratios, and dozens of new international and specialty funds have been created in recent years, driving up the average MER because they are usually more expensive to manage.

The specialty funds are particularly expensive in segregated form because they are riskier, and the insurance "premium" an investor must pay is based on the risk. A portfolio of biotech stocks, clearly, is a lot more likely to lose money in a 10-year period than a conservative portfolio of utilities and banks. That goes a long way to explaining why TD Asset Management Inc.'s science and technology seg fund has an MER of almost 6 per cent, while Sun Life Financial Inc. and CI Fund Management Inc. offer a segregated dividend fund that costs just a shade over 2 per cent.

There's another side to seg funds that helps to attract more than just those Nervous Nellies who don't want to lose any capital.

Because seg funds are insurance contracts, they have unique legal status that mutual funds don't. For example, in most cases they cannot be claimed by creditors -- which makes them appealing to self-employed people like doctors who want to protect their assets in the case of a lawsuit. They're also exempt from probate fees, the taxes imposed when you die and your will is executed.

People who buy seg funds for those reasons usually buy versions with a 75-per-cent guarantee, which are considerably cheaper -- since, obviously, the odds of the market falling 25 per cent in a decade are much, much lower.

For that reason, and simply to prevent being priced out of the market, some seg fund providers have focused their business on investors who want the creditor protection or who would like to avoid probate fees.

"My personal view is that somebody who can benefit directly from those types of tools is the best fit for this product," said Mary Anne Stewart, who runs the segregated fund business at Mackenzie Financial. More than two-thirds of Mackenzie's seg fund assets are in funds with the 75-per-cent guarantee, a reflection of the company's strategy to concentrate on the self-employed.

Even Mr. Milevsky, who believes low fees are critical to long-term returns, concedes there are some people for whom seg funds make sense. He uses an analogy: Imagine if everyone were charged the same premium for life insurance. A healthy young university student would be paying too much. But an overweight smoker in his sixties would be getting a bargain.

A similar thought process applies to seg funds, which are nothing more than mutual funds with fixed-price insurance. If you're a young, employed person with decades before retirement, you probably don't want them. If you're at risk of bankruptcy, or you need equity returns but will lie awake at night worrying, or you believe the odds are high that you will die in the next decade, they might be right for you.

"There's a segment of the population for whom these are really a bad idea," says Mr. Milevsky, and another segment who probably need them. You just have to figure out which group you're in.

Top 10

Segregated funds were atiny part of the investment industry until the 1990s, when insurance companies began offering 100-per-cent guarantees on investors' money. Mutual fund providers jumped into the game, too, but insurers still dominate the field. Here are the biggest players, ranked by seg fund assets under management.

Segregated fund assets - as of March, 2004


Great-West Life........$14,700


CI Fund Management*.$5,500

Maritime Life#...........$5,100

Industrial Alliance........$3,500

Transamerica Life.......$2,800

Empire Life...............$2,000

Standard Life.............$1,600


Primerica Life...............$601

Total Canadian industry.....$46,800

-* includes Sun Life

#Manulife acquired Maritime Life in April as part of its purchase of John Hancock.


Series schedule


Rapid trading in mutual funds bears marks of market timing

Mechanics of market timing, who does it, who doesn't and why


Proposed rules for fund governance favour industry, critics say


Not all fund managers have suffered the same pain as investors


Fees and fund performance don't always go hand-in-hand


Segregated fund fees on the rise


Dos and don'ts for the investors

On the Web

Follow the mutual fund series this week on our website

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