“Beware of Too Good to Be True Investments”–A Getsmartaboutmoney piggyback…

Beware of Too Good to Be True Investments

Alison Griffiths looks into segregated funds in this post: I agree with her points, but I would have hit home a bit harder.

The risk premium on Canadian equities over bonds, that is the return you are trying to get hold of, above bonds, by investing in equities, has averaged 3.4% per annum from 1900 to 2011 and from 2002 to 2012, 0.8% per annum. 

Many equity orientated segregated funds have total expense ratios exceeding this risk premium.  What this means is that by buying the segregated fund you are giving up the equity return in exchange for an asset which is guaranteed to produce at a minimum no real return or at a maximum a return which will be some 3% to 4% per annum less (annual costs) than the compound return on the fund’s benchmark.  

Really, if you are so concerned about risk, you should be investing in lower risk assets.  The guarantee only covers the initial amount invested, not any dividend or other return on the investment.  In fact, an investment that failed to perform but yielded 3.5%, and compounded, over ten years would be worth 1.4106 gross of all charges and taxes.  In this case, the investor could afford to lose some 30% of this value before the guarantee on the investment would kick in.  Moreover, if markets were to have fallen in the interim, reinvested dividends would have yielded a higher compound gross return. 

Bonds are of course more accessible and in market downturns have tended to be much more liquid and secure.  Importantly, if your portfolio is being properly managed, and you are risk averse, your assets could easily be structured to ensure that you are not exposed to stock market risk over any ten year period, or more if need be.  

Therefore, what you might find is that if you are holding segregated funds, is that you might be holding an excessive allocation to higher risk assets.   Also, there is the temptation, if you are holding a guaranteed capital investment, to buy into higher risk equities.  Those who recommend segregated funds may well be a) unable, for one reason or another, to structure a portfolio to manage risk and meet your needs, and/or b) be influenced by the initial commissions and trailer fees they receive for selling them. 

Segregated funds are going to be exposed to greater risk than normal funds during the term of the contract because of the higher costs.  Many people are nervous over stock market risk because of the impact of a decline in capital on their ability to support their financial outgoings. Segregated funds will do no such thing during a risk event, if you need access to capital, and if this occurs within the contract term.  

Indeed, I have seen investors who were sold these investments (“advisors” knowing full well that the client had income needs) having to draw down on the capital invested during market declines.      

Additionally, because of their high costs, there will be no dividend or interest income from them.  Dividend paying stocks and low cost collective investment vehicles are an important component of portfolios for individuals looking for income.  Holding segregated funds in a portfolio will more often than not mean that the portfolio will be short on accessible/liquid assets (you can sell a segregated fund but the costs and the effective penalties would inviolate even their limited rationale) and/or income producing assets.   This causes problems in the construction of the portfolio, the planning and the management of the portfolio to meet financial needs over time. 

One of the primary reasons for holding equities these days, given the uncertainty over capital return, is the high dividend yield relative to bonds.  Holding segregated funds could a) force you to consume more capital from your existing portfolio, b) force you to take on more risk to invest in higher yielding assets and c) force you to take higher risk in the segregated fund to overcome the lower portfolio yield, the higher costs and the need to hold lower risk assets to compensate for the effectively illiquid segregated allocation. 

Even if you have a long time horizon and do not need income and or capital, then a lower cost sensibly structured portfolio may end up being more efficient even if investments continue to struggle.

One problem that was not highlighted, was that segregated funds require an insurance license to sell, and those only licensed to sell insurance may not be licensed to sell or manage a wider range of assets.   If the “advisor” who is responsible for recommending you investment products is only licensed to sell segregated funds, well…………….

And, of course, segregated funds have a whole host of other bells and whistles which make it extremely complex for the ordinary investor to work out exactly what the deal is.   The lifetime income benefit/guaranteed withdrawal benefit options available also further complicate the assessment of segregated funds by individual investors, but this another subject altogether.   If you look at my documents section you will find detailed analysis of these investments.

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