Canadian Nesters have a slightly different set of investment options, reflecting the different regulatory environment in that country. The financial-services sector in Canada works within a different taxation regime, and both investment and estate laws vary from those in the United States. One outgrowth of these regulatory differences is segregated funds, an insurance industry variation on the concept of mutual funds.
Up to a point, mutual funds and segregated funds work in similar ways. Both are ways for small investors to take advantage of a large, professionally managed and well-diversified portfolio. The fund's managers pool money from thousands of small investors, transforming them into the equivalent of one large institutional investor. Each individual investor benefits from the growth of the fund, sharing increases in the portfolio's value, profits from selling successful investments and dividend income. Unfortunately, each investor also shares the risk that a market decline will sap the value of their investment.
The fundamental difference between the two types of funds is that segregated funds are, at their base, an insurance product. They're similar to the variable annuities sold by American companies, though there are distinct differences. The investment is held for a specific period, like bonds, before reaching its maturity date. At that date the funds can be reinvested for another term or withdrawn without penalty. You can protect 70 to 100 percent of your investment against losses, if markets are down at maturity. Segregated funds also offer a reset option, allowing the investor to lock in market gains and increase the guaranteed return in exchange for resetting the maturity date.
Mutual Funds' Edge
There are benefits to each type of fund. With mutual funds there is no set maturation date and the investment can be withdrawn at any time, though it might be subject to penalties. The management fees for mutual funds are also lower, because segregated funds have to cover the cost of their guarantees and insurance features. The lower cost means mutual funds will usually give greater returns than comparable segregated funds. However, segregated funds' insurance features offer benefits that, combined with their guarantees, make them attractive for some investors despite their lower returns.
One of the most significant advantages of segregated funds is that, like a life insurance policy, when you die, the funds are paid to your named beneficiaries rather than the money going through lengthy, costly -- and public -- probate. This makes the funds available immediately to defray burial costs or estate taxes, if necessary. If you should die while the markets are down, your heirs will get back the same guaranteed minimums you would have. Segregated funds are also protected from your creditors thanks to their insurance status. Mutual funds, however, are only shielded from your creditors if they're held in a registered retirement account.
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