Why superannuation matters in income protection insurance

Income protection insurance doesn’t just protect income, it protects clients’ lifestyles. However, there is a greater need to regard superannuation protection as a must, rather than an option within this cover, writes Col Fullagar.

The average percentage of after tax income spent servicing debt in Australia is 45 per cent, according to a Genworth International Mortgage Trends report released this year.

In its Economic Roundup, the Australian Treasury found that the ratio of household debt to annual household income was around 160 per cent, and household saving (ie, the part of current after-tax income that was not directly used) was around 2 per cent in 2008.

For those reliant on their ability to work in order to derive an income, sickness or injury will very quickly have a devastating impact on them and their family.

Income protection insurance is often touted as an essential component of the risk insurance portfolio of clients because “it will protect your income”. While the sentiment is definitely correct, the wording might benefit from a slight adjustment.

There are two things that can be done with income; it can be spent and it can be saved. That which is spent will dictate the current lifestyle of the client and their family, and that which is saved will dictate their future lifestyle.

Thus, the adjusted wording of the above statement might be that income protection insurance is not protecting income – it is protecting the current and future lifestyle of the client and their family. The distinction is important.

When it comes to current lifestyle, it seems that on average people spend about 90 per cent of their income maintaining it – that is, 100 per cent of income less 9 per cent compulsory superannuation and 2 per cent average savings, as per above.

If, however, those same people can only protect a maximum of 75 per cent of that income under income protection insurance, the problem becomes apparent – current lifestyle may be reasonably maintained, but the ability to save is likely to quickly cease.

In the short-term, this may not be too big a problem, but over time the funding gap grows exponentially.

Case study

Jeff is aged 45 and earns $200,000 a year.

He contributes 10 per cent of his yearly income into superannuation.

Jeff starts to suffer from depression which over time becomes increasingly debilitating. Finally, he is forced to stop work, and he remains off work for the best part of the next two years.

The benefits he receives from his income protection insurance are a lifesaver, and enable Jeff and his family to keep up their mortgage payments and a reasonable standard of living. Unfortunately, however, he is unable to maintain his superannuation contributions over the two years he is not working.

Assuming inflation is at a steady 5 per cent per annum, when Jeff retires at age 65, the two year suspension of contributions will have grown to an overall funding gap of around $105,000 – ie, $20,000 x 2 x 0.05 compounded over 20 years.

Of course, the longer Jeff is unable to work the greater the problem, and in fact, if Jeff remained disabled through to age 65, his income protection benefits would cease and he would likely be left destitute.

The only possibly good news for Jeff might be that he would have seen this coming for many years, and thus would have had time to discuss legal options in regards to the appropriateness of the financial advice he had originally received.

An ironic value of advice might well be that the client has someone who can be held accountable – and the client may be able to afford to hold them accountable.

The issues associated with a superannuation funding gap are not only created by the duration of disability. Consider the plights of Jack and Jill.

Jack is aged 35 and is unable to work for five years due to an illness. He has no income protection insurance, so in order to survive, he has to cash in all his assets including his superannuation. The good news is, however, that he has 25 years from age 40 to 65 to recover financially.

Jill is aged 55 and is unable to work for five years due to an illness. She is in the same position as Jack, in that she is forced to cash in all her assets, including her superannuation. The really bad news for Jill, is that she only has five years (from age 60 to 65) to recover financially, which makes it just that much more difficult for her.

The point is that the older the client, potentially, the more important it is to protect future lifestyle – because the ability to rebuild it grows increasingly difficult.

A primary role of insurers is to provide products that enable advisers to, in turn, provide reasonable advice. 

Around 15 years ago, it was the realisation of the problem surrounding the maintenance of superannuation savings while on a disability claim that led insurers to introduce an optional benefit to income protection insurance that is commonly referred to as the superannuation protection option.

The original concept and design was simple:

• Up to 75 per cent of earnings could be protected under the basic policy and
• Up to an additional 10 per cent of earnings could be protected under the superannuation protection option.

Thus, up to 85 per cent of earnings could be protected in total.

If disability occurred, the 75 per cent would be paid to the client, and the 10 per cent would be paid into their superannuation as a substitute for their own “suspended” contributions. 

Because the amount in excess of 75 per cent (ie, the additional 10 per cent) was not going directly into the hands of the client, the theory was that it would not impact to any material extent on the client’s motivation to return to work.

In essence, the problem of maintaining some level of superannuation savings was reasonably solved.

This innovative optional benefit received general support, and was introduced by most of the mainstream insurers.

As time went on, however, the clarity and simplicity of this optional benefit has been blurred such that today the choice facing advisers is somewhat more complex.

Returning to Jeff’s situation, set out below is how he would have fared had he been offered, and taken up, the original superannuation protection option.

The maximum protection package for Jeff would have been:

Basic cover of $200,000 x 0.75/12 = $12,500 a month
Superannuation cover of $200,000 x 0.1/12 = $1,670 a month
Total = $14,170 a month
Replacement percentage = 85 per cent

In the current risk insurance market, there are several ways in which the superannuation protection option is now structured.

(i) Original basis

Only one insurer was identified as using the original basis of implementation.

With that insurer, the client can insure up to 75 per cent of basic income protection insurance cover, plus up to 10 per cent of superannuation cover, for a total maximum replacement ratio of 85 per cent.

Another insurer did something similar; however, the maximum superannuation cover was 5 per cent of earnings for a total replacement ratio of 80 per cent.

(ii) Contributions deducted from earnings

Several insurers covered up to 100 per cent of the contributions made to superannuation in the previous 12 months, including salary sacrifice and employer contributions; however, this amount was then deducted from total earnings in order to arrive at a benefit amount under the basic income protection insurance policy.

Thus, in Jeff’s situation, his benefit amount would be:

Basic cover of ($200,000 - $20,000) x 0.75/12 = $11,250 a month
Superannuation cover of $20,000 x 1/12 = $1,670 a month
Total = $12,920 a month

Replacement percentage = 77.5 per cent, which represents an additional $420 a month over the standard 75 per cent cover

(iii) Contributions not deducted from earnings

One insurer allowed up to an additional 12 per cent of the basic benefit amount to be insured as superannuation contributions. The basic benefit amount was based on the client’s full earnings, without the deduction of superannuation contributions. 

Therefore, in Jeff’s situation the benefit amount would be:

Basic cover of $200,000 x 0.75/12 = $12,500 a month
Superannuation protection cover of $12,500 x 0.12 = $1,500 a month
Total = $14,000 a month
Replacement percentage = 84 per cent

Another insurer had a variation of the above, whereby the basic cover could be increased by up to 25 per cent of superannuation contributions.

Basic cover of $200,000 x 0.75/12 = $12, 500 a month
Superannuation cover of $20,000 x 0.25/12 = $416 a month
Total = $12,916 a month.
Replacement percentage = 77.5 per cent

The reason for the difference in attitude between insurers appears to be tied to the belief by some that failing to reduce earnings by the amount covered under the superannuation option creates an adverse double dipping situation – ie, the insured can insure 75 per cent of earnings (including superannuation) under their basic cover, and then a further percentage of the same amount as the superannuation option.

In reality, however, the basic cover still only represents 75 per cent of what the insured previously used to support their lifestyle.

If the insured’s earnings are further reduced by deducting superannuation contributions, the replacement percentage under the basic cover becomes 67.5 per cent in Jeff’s example – ie, ($200,000 - $20,000) x 0.75/12 as a proportion of $200,000/12.

Irrespective of the different approaches taken in arriving at an insured benefit amount, the approach in regards to other aspects of the superannuation contributions option appears reasonably consistent.

Benefit payment 

The majority of insurers indicated they would pay the superannuation benefit amount direct to the designated superannuation fund, rather than paying it to the claimant.

Taxation

Various insurers were asked about their understanding of the tax position in regards to the option. 

The view generally held was (and, of course this is a general view which should be checked for each particular client):

• Premiums for this optional benefit would be tax deductible;
• If the policy is owned by the employer, then the benefit payments to the designated superannuation fund would be considered employer/concessional contributions that will count towards the superannuation guarantee obligations;
• If the policy is owned by the insured, then the benefit payments to the designated superannuation fund would be considered non-concessional contributions, and be taxed as normal income to the insured. The insured may claim the contribution as a tax deduction if it can be demonstrated that they are “substantially self-employed” (Section 290 ITAA 1997).

Irrespective of the philosophies behind the different bases of cover, the issues facing the adviser include:

• What priority is the client placing on having maximum coverage?
• How to balance the situation of an insurer with a higher cover percentage against another insurer with a lower premium rate;
• How to balance the situation of an insurer that has an appropriate contribution option against another insurer that is more appropriate in its basic cover; and
• Identifying which contribution option structure will best suit a particular client’s need.

Income protection insurance is not just about protecting income – it’s about protecting lifestyle. For clients who want maximum cover, and who seek protection of their future lifestyle by way of ensuring the ability to make ongoing superannuation contributions, the various superannuation protection benefits available are not an option – they are a must. 

Col Fullagar is the national manager for risk insurance at RI Advice Group.