Thu | Sep 19, 2019

Oran Hall | Upsides and downsides of segregated funds

Published:Sunday | August 25, 2019 | 12:26 AM

Equity-linked life insurance policies have an insurance element and an investment element.

The policyholder pays one premium, a portion of which pays for life coverage and a portion of which is invested in a segregated fund. The latter is a dedicated fund, which is not commingled with the general funds of the life insurance company.

The investment portion of the premium may be invested in one or more segregated funds.

Because segregated funds cannot be mixed with the funds of the life insurance company, policyholders are protected against the life insurance company encroaching on them or misusing the funds of the policyholders.

Segregated funds are similar to mutual funds and unit trusts so many of the benefits of these investment vehicles also accrue to policyholders whose money is invested in them. There are many different types to satisfy a wide range of investment objectives.

Just as unit trusts and mutual funds pool the money of investors and invest it in a portfolio of investment assets, segregated funds pool the money of many policyholders and invest it for their benefit. One downside of pooled segregated funds is that they are not customised to the needs of individual policyholders. The benefits accrue to all policyholders in proportion to the share of units of the fund that they own.

They also have a unitised fund structure. The unit value is determined by dividing the number of units into the net asset value of the fund. Unit values fluctuate depending on changes in the value of the fund due to changes in the market prices of the financial assets which make up the fund and the level of income generated by them.

But whereas the holders of units in a unit trust or mutual fund may routinely surrender their units for cash, policyholders who own units in the segregated fund are not encouraged to surrender them although they are not generally prohibited from doing so.

This is particularly important in light of how the premiums of universal life insurance policies – which tend to be linked to segregated funds – are calculated. Generally, the premium is fixed, but as the policyholder gets older, the mortality charge, which pays for the life coverage, increases.

Because the premium the policy holder is required to pay is not adjusted, the additional portion of the mortality charge is paid for from the investment portion of the policy. Withdrawing from it may put the policy at risk.

In addition to the investment portion of the policy, policyholders may be able to contribute a regular additional investment premium, if there is such a provision, and boost the value of the investment portion of the policy.

If policyholders refrain from liquidating units, they increase the ability of the fund to generate returns which may be significant and prove useful in the long term for purposes such as retirement.

Like mutual funds and unit trusts, the segregated funds are managed by professional investment managers who, by their training and experience, are equipped to manage the affairs of the fund for the benefit of the policyholders. Of course, the insurance company also benefits, but from the management fees it levies on the fund for the services it provides.

Segregated funds allow significant scope for diversification. Some funds may be dedicated equity funds or bond funds but may still be diversified by investing in several markets or industries, for example. The scope of the diversification may be much wider, though, as funds may invest in a wide range of assets and reduce portfolio risk. At the same time, the asset mix, which reflects the type and level of diversification, has much to do with the resilience of each investment fund, or portfolio.

An additional benefit to policy-holders who own equity linked insurance policies is that the growth in the value of segregated funds is enhanced by the favourable tax treatment of the income and gains which accrue to them.

The returns generated by segregated funds are capable of adding great value to equity linked polices because they are added to the sum insured when death benefits are being paid. Having equity linked policies should not, however, be used as an excuse for not creating an investment portfolio. Equity linked insurance policies are life insurance policies first and foremost.

- Oran A. Hall, the principal author of The Handbook of Personal Financial Planning, offers personal financial planning advice and counsel.finviser.jm@gmail.com