The case for segregated funds: faster payouts, privacy, and lower costs for beneficiaries

When a loved one passes away, the financial implications for the family left behind can be significant. Many families expect a timely distribution of assets, yet the reality of estate settlement can be complex and time-consuming. One way to help assets reach your beneficiaries quickly, with more privacy and lower legal fees, is through Segregated Funds (aka Seg Funds) with a named beneficiary.

In this article, we’ll explore why Segregated Funds can be a useful choice for estate planning, focusing on the time it takes for beneficiaries to receive their funds, the privacy these funds offer, and the potential cost savings compared to other investment vehicles such as Mutual Funds or standard investment accounts.

Probate vs. Segregated Fund Payouts

One of the most significant differences between Segregated Funds and other forms of investment is how quickly the funds are disbursed to beneficiaries.

Segregated Fund death benefits paid to a named beneficiary are processed by the insurer once it has received all the necessary documents, without waiting for the estate to be settled. This can provide families with financial support much sooner, which can be critical for covering immediate expenses or addressing other pressing financial needs.

In contrast, investments that are part of an estate and go through probate usually take longer to reach beneficiaries. Before distributing the estate, the executor should also get a clearance certificate from the Canada Revenue Agency (CRA), which can only be requested after the deceased’s tax returns have been filed and assessed. Settling an estate can take many months, and complex estates can take longer. During this time, the funds remain inaccessible to beneficiaries, potentially creating financial strain during an already difficult period.

Staying Invested in Equities with Confidence, Even as You Age

As Canadians approach retirement or their later years, it is common to adopt a more conservative investment strategy. Many investors move a greater percentage of their portfolios into fixed-income investments, such as bonds, in an effort to reduce risk exposure and volatility. This shift is driven by a desire for financial security, especially when nearing or entering retirement, where the fear of significant losses in equities, and insufficient time to recover from them, becomes a primary concern.

While this "conservative shift" might help reduce anxiety, it often comes at the cost of potential growth. Fixed-income investments typically offer lower returns than equity markets, meaning that investors sacrifice the opportunity for higher returns to achieve peace of mind.

However, Segregated Funds offer a compelling alternative to this traditional approach. With the built-in guarantees unique to Segregated Funds, investors can continue benefiting from to higher-return equity investments without the same level of fear or risk. These guarantees ensure that a portion of your initial investment will be protected, even in the event of a market downturn, giving investors the confidence to stay in equities longer, with greater peace of mind and comfort.

This ability to remain invested in potentially higher-risk, higher-reward assets, while still protecting against downside risk through Segregated Funds’ guarantees, allows you to continue seeking growth without sacrificing your "sleep quotient", the peace of mind that your investment is safeguarded. This feature is especially valuable as you age when conventional advice might push you toward lower-risk, lower-return investments. Segregated Funds provide the flexibility to maintain a more aggressive investment posture with the security of capital protection, allowing you to balance growth potential with risk management.

Key Benefits of Segregated Funds

1. Principal Guarantees: One of the most compelling features of Segregated Funds is their principal guarantees, which protect a set percentage of the amount you deposit. This protection comes in two forms:
   1. Maturity Guarantee: At the maturity date, you are guaranteed the greater of a) the current market value of your investment or b) a minimum guaranteed amount (less any withdrawals and fees).
   2. Death Benefit Guarantee: If you pass away, your named beneficiaries will receive the greater of a) the market value of your investment or b) a minimum guaranteed amount (less any withdrawals and fees). This feature provides peace of mind by ensuring that your beneficiaries will receive a stable benefit even in fluctuating markets.
2. Privacy: One often overlooked but highly valuable aspect of Segregated Funds is the privacy they offer. Unlike non-registered investments that go through probate and become part of the public record, Segregated Funds remain private. When you name a beneficiary on a segregated fund, the proceeds are paid directly to that individual and do not become part of the estate. This avoids probate entirely and shields the contents of your segregated fund from public disclosure, ensuring your financial affairs remain confidential. For many individuals and families, this aspect of privacy is a significant advantage. Probate is a public process, meaning anyone can access details about the estate, including assets and beneficiaries. By utilizing Segregated Funds, investors can protect the confidentiality of their assets and maintain their family's financial privacy, shielding them from potential scrutiny or unwanted attention.
3. Estate Preservation: When the annuitant (the person whose life the contract is based on, who may not be the owner) dies, the death benefit is paid directly to your named beneficiaries, allowing them to bypass the estate settlement and probate process. This needs a named beneficiary: a death benefit payable to the estate goes through probate like other estate assets. With a named beneficiary, your beneficiaries receive their payout faster, and probate fees on that amount are avoided. Income tax is not avoided: for a non-registered contract, any gain is still taxable to the contract owner (where the owner is the person who died, it is reported on their final tax return), and registered contracts, such as an RRSP or RRIF, follow their own rules. Additionally, because of the privacy benefits, the payout remains confidential, further enhancing estate preservation.
4. Minimize Fees: Segregated Funds with a named beneficiary allow you to minimize probate, executor, legal, and accounting fees by bypassing probate for assets held in these contracts. This can lead to significant cost savings for your beneficiaries, keeping more of your estate intact for your loved ones rather than lost to administrative fees.
5. Provide Possible Creditor Protection: Because Segregated Funds are an insurance product, they may be protected from creditor claims, including in bankruptcy, depending on provincial law and who the beneficiary is. Protection isn’t guaranteed and depends on the facts. This feature can be attractive for business owners or self-employed individuals, as an added layer of protection for personal assets.
6. Lock in Gains Without Selling (Resets): Some Segregated Fund contracts offer a feature called resets, which allows you to lock in investment gains without selling. Whether you can reset, how often, and whether a fee applies depend on the contract. For example, if your investment has grown and you reset, your guaranteed value rises to the new, higher market value. This effectively increases your guaranteed minimum, protecting those gains, and it usually also resets the maturity date.
7. Preserve Capital and Upside Growth Potential: Segregated Funds offer protection against market downturns through maturity and death benefit guarantees. These guarantees protect the guaranteed amount (a set percentage of your deposits, less withdrawals and fees) at the contract’s maturity or upon death, regardless of market performance. Additionally, many segregated fund contracts provide reset features (as mentioned above), which allow you to lock in investment gains, helping to capture upside growth while maintaining downside protection.

How Segregated Funds Differ from Mutual Funds

While Mutual Funds and Segregated Funds share some similarities, such as professional portfolio management and diversification across asset classes, there are key areas where Segregated Funds stand out:

• Bypassing probate: Mutual Funds held in a non-registered account generally go through the estate, while Segregated Funds with a named beneficiary don’t, which helps with privacy and quick payouts. (Registered plans with a named beneficiary, such as an RRSP, RRIF or TFSA, can also pass outside the estate.)
• Creditor protection: Segregated Funds may provide creditor protection, depending on provincial law and who the beneficiary is, which can be beneficial for business owners and professionals. Mutual Funds do not offer the same protection in most cases.
• Guarantees: Segregated Funds guarantee your principal (or a percentage of it) at maturity and at death, while Mutual Funds do not provide this level of protection.
• Privacy: Unlike Mutual Funds, Segregated Funds provide the added benefit of privacy, ensuring that the contents and proceeds of your investment are not subject to public disclosure through probate, maintaining the confidentiality of your estate.
• Ability to lock in gains: Segregated Funds offer reset features that allow investors to lock in market gains without selling, whereas Mutual Funds typically require a sale to realize gains.

The Cost Comparison: Mutual Funds vs. Segregated Funds

In addition to the speed of payout and the additional benefits mentioned, Segregated Funds offer another advantage: cost savings. Probate, executor fees, legal, and accounting costs can add up quickly when dealing with traditional investment vehicles. Let’s look at how these costs compare between Mutual Funds and Segregated Funds:

Probate Fees: Probate fees vary significantly across provinces:

• Ontario: has some of the highest probate fees. Estate Administration Tax is charged on the value of the estate above a set threshold, so on a large estate it can run to many thousands of dollars.
• Alberta: probate (surrogate) fees are more modest: a flat court fee based on the net value of the property in Alberta, which is small compared with Ontario and BC.
• British Columbia (BC): has significant probate fees, charged on the value of the estate above a small threshold, at a higher rate on the portion above a second threshold.

While these fees may seem small in some provinces, they can be avoided on the amount held in Segregated Funds with a named beneficiary, as that amount bypasses the probate process. This can lead to faster payouts and cost savings for beneficiaries.

Executor Fees: In Alberta, the Surrogate Rules don’t set a percentage: executors may receive “fair and reasonable” compensation, based on factors such as the gross value of the estate, the complexity of the work and the time spent. A segregated fund death benefit paid to a named beneficiary is handled by the insurance company rather than the executor, so it can reduce the executor’s work and the compensation tied to the estate’s value. Executor fees still apply to any assets that go through the estate.

Legal and Accounting Fees: Legal and accounting costs depend on the size and complexity of the estate and the firms involved. Assets paid directly to a named beneficiary aren’t administered through the estate, which can reduce these costs, although the estate still needs the deceased’s final tax returns and the administration of any other assets.

Together, probate, executor, legal and accounting costs on a large estate can add up to a significant sum. Holding assets in Segregated Funds with a named beneficiary can keep these costs off the amount held in them, benefiting the beneficiaries rather than being absorbed by legal, probate, and executor fees.

Addressing the Criticism of Segregated Fund Fees

One common criticism of Segregated Funds is the Management Expense Ratio (MER), the ongoing fee charged by the insurance company to manage the investment. While these fees can be higher than those associated with standard mutual funds, it’s important to consider the broader picture.

Yes, there are ongoing management fees with Segregated Funds, but the faster payout (without waiting for the estate to be settled), combined with lower probate and legal fees on the amount held, may outweigh the costs associated with the MER. Whether it does depends on how long you hold the contract, the difference in fees, and the probate fees in your province.

An additional step for investments that pass through the estate is the clearance certificate from the Canada Revenue Agency (CRA). It confirms that the estate has paid all amounts of income tax and GST/HST owing (or that the CRA has accepted security for them). The executor should get one before distributing the assets they control: without it, they can be personally liable for unpaid amounts, up to the value of the assets distributed. The request can only be made after the deceased’s returns have been assessed, so this step can often extend the timeline for settling the estate, which can be stressful for beneficiaries waiting for their inheritance.

In contrast, a segregated fund death benefit paid to a named beneficiary doesn’t pass through the estate, so the beneficiary doesn’t have to wait for the executor to get a clearance certificate before receiving it. Income tax on any gain in the contract still applies (where the contract owner is the person who died, it is reported on their final return). This allows beneficiaries to access the financial support they need in a timely manner, once the insurer has the documents it needs, instead of enduring potentially lengthy delays.

For beneficiaries, faster access to funds and fewer legal and administrative steps can provide peace of mind during a challenging time. Receiving funds without waiting for the estate to be settled, and without probate on that amount, can offset the Management Expense Ratios (MERs) associated with Segregated Funds. Instead of waiting months, or even longer, for assets to be distributed, Segregated Fund holders can know that the amount held with a named beneficiary is paid directly to their loved ones, without probate delays or fees.

Segregated Funds as a Tool, Not the Whole Portfolio

It’s important to note that Segregated Funds don’t need to represent the entirety of one’s assets or investment portfolio. Instead, they can be used strategically as part of a well-rounded estate plan. For example, some portion of an investor’s assets could be placed in Segregated Funds to ensure faster payouts, privacy, and cost savings for beneficiaries, while other assets remain in different investment vehicles. This approach provides flexibility in estate planning and allows individuals to optimize both their investment strategy and their estate's efficiency.

By incorporating Segregated Funds alongside other assets, investors can diversify the tools at their disposal, helping to meet both short-term and long-term estate planning needs. It offers a balanced approach, where some assets are set aside for faster disbursement to beneficiaries, while others may remain invested for the long term.

Conclusion: A Strategic Choice for Estate Planning

Segregated Funds offer clear advantages when it comes to estate planning. The quick payout, potential creditor protection, privacy, and potential cost savings can make a real difference for families in the aftermath of a loved one’s passing. While there are ongoing fees such as the Management Expense Ratio (MER), these costs may be offset by lower probate, legal, and executor fees. Most importantly, Segregated Funds with a named beneficiary give beneficiaries timely access to the assets they need, when they need them most, while keeping that amount out of the public probate process.

Moreover, Segregated Funds don’t have to be an all-or-nothing decision. They can serve as one component of a comprehensive estate plan, ensuring that families are financially protected without being burdened by unnecessary delays, fees, or public scrutiny.

When considering your estate planning options, it’s worth discussing with a financial advisor whether Segregated Funds are the right choice for you and your family.