I never thought I would speak in favour of mutual funds with management expense ratios (MERs) above 2.5%. But that day could be here: I am beginning to think, having recently reviewed some personal finance books by York University professor Moshe Milevsky and Weigh House Investor Services president Warren MacKenzie, that there might actually be a caseto be made forsegregated mutual funds.
Segregated funds (also known as guaranteed income funds) dont make sense for younger investors because of the relentless drag of their high MERs, but investors near or in their retirement years appear to bea different matter. The funds come with certain insurance-like features that make them more expensive than ordinary mutual funds but, nonetheless, could be useful to older investors. They include:
guaranteed return of 75% or 100% of principal (as selected by the investor) after a ten-year period or on death
an ability to reset the value of a fund at a higher level (if market goes up) and thus guarantee an amount higher than ones original deposit.
How might these features appeal to seniors? Imagine a bear market knocking a retirement fund down by 50%. That setback isa lot more serious for a senior citizen because they need to make withdrawals from their retirement fund in order to live, and cant wait a long time for the market to recover. The capital guarantees of a segregated fund could help insure against the risk of outliving funds by restoring 75% to 100% ofprincipal after 10 years.
Next, imagine if the investor passes away during a bear market and his investments are down more than 50%. If the investment holdings were segregated funds, beneficiaries would still get 75% or 100% of the principal.
Furthermore, as insurance products, segregated funds have several convenient features. Notes Warren MacKenzie,author of The Unbiased Advisor:
on death, the proceeds of a segregated fund bypass the estate and go directly to the named beneficiary, so there is no extended wait or probate fees.
unlike regular life insurance, no proof of insurability is required — Even if your doctor has told you that you have only a short time to live, you can still receive the income guarantees
unlike wills — where all the beneficiaries are aware of who gets what — beneficiaries of segregated funds (and other insurance products) are not made public — Many persons use these products to provide for beneficiaries without creating acrimony within the family, says MacKenzie.
a drawback is that part of the proceeds from the fund may be taxable: this is the top-up portion, which is defined as the difference between the market value and the original (or reset) value.
The ability to reset the value of the fund has some utility. The high MERs will erode returns substantially over time but should the market run up at some point, the investor can freeze the higher value and offset MERs or even increase the size of their benefit.
There are other features of segregated funds, such as creditor protection but they are gist for another post. So too is the importance for shopping aroundfor segregated funds; the case for segregated funds also depends on finding offerings that dont charge excessively for the insurance features.