A look at TPD in Stronger Super

The Stronger Super changes relating to the types of insurance held in super that came into effect from 1 July 2014, probably have the greatest impact on total and permanent disability (TPD) insurance out of the three main types of life insurance available in retail and other large funds.

Stronger Super has meant that insurance in super must align with at least one of four conditions of release in the super legislation - death, terminal illness, permanent incapacity or temporary incapacity.

Prior to this date, two alternative TPD definitions were available in super-owned policies - ‘any occupation' and ‘own occupation'. After the changes, only the ‘any occupation' definition is available to members newly taking out or being offered TPD insurance.

‘Any occupation' TPD (which aligns with the ‘permanent incapacity' condition of release in the super legislation) pays out a benefit to a member who is unlikely to work again in an occupation to which they are suited by training, education or experience.

In contrast, own occupation TPD cover has a less restrictive definition of incapacity and is therefore a more generous definition (and usually 40 per cent to 50 per cent more expensive).

It will pay out when the claimant is unlikely to be able to work again in their occupation at time of claim (and sometimes their occupation at time of applying for the cover as well).

That is, the insurer does not have to determine (given the claimant cannot work in their own occupation) whether the claimant could reasonably work in another without undertaking new training, new education or obtaining new experience.

This definition does not align with the permanent incapacity release condition, and therefore is not allowed under Stronger Super.

So given only the less generous ‘any occupation' TPD definition is now available in super, is it still potentially worthwhile holding TPD cover in super?

The answer is ‘yes' for a number of reasons.

First, the ‘any occupation' TPD definition is sufficient for a large number of fund members.

People who have had a steady career in the one occupation or industry probably do not require ‘own occupation' cover. If they cannot do their job, what else could they do (without re-training, re-education or obtaining new experience)?

However, what about those people who may be better off with ‘own occupation' TPD cover?

For example, what about those with wide experience and a wide range of roles in their background or current role who may not be able to perform their own occupation, but could perform another occupation without too much of a stretch?

In these situations, an ‘any occupation' claim might be declined. The other set of people suited to the ‘own occupation' definition are those who would not wish to take up a new occupation if anything were to happen to them.

The second point to make here is that with product innovation in the marketplace, such clients ‘can have their cake and eat it too'.

A number of providers offer ‘TPD optimiser' solutions, that allow:

• Policies with the ‘any occupation' TPD definition to be held within super - therefore attracting all the benefits outlined above of holding TPD insurance in super; and
• A linked ‘own occupation' policy to be held outside super - and therefore allowing access to the more generous TPD own occupation definition without breaching the Stronger Super requirements.

Finally, holding TPD in super still has the benefit up front of tax efficient funding of premiums.

It also has benefits at the ‘back-end' (i.e. at claim). Once the insured amount is paid from the insurer to the member's account, superannuation benefits can be:

• Taken as a lump sum (with limited tax, and no tax after turning 60); 
• Taken as a tax effective pension, that will generally have a tax free portion and qualify for a 15 per cent tax offset. Pensions will become tax free once age 60 is attained;
• Retained in the fund, which could also have the benefit of maximising Centrelink entitlements, such as the Disability Support Pension and associated benefits such as the Pensioner Concession Card. Additionally, partial lump sum withdrawals from super are not income for means testing purposes and the resulting cash will not be means-tested assuming the amount withdrawn is spent within 14 days; or
• Any combination of the above.

What about tax at the back end?

The non super benefit will be paid tax-free.

The super death benefit will be tax-free if paid to a tax dependant such as a spouse, child under 18 or a financial dependant (referred to as a ‘death benefit dependant' in the tax legislation).

TPD benefits will not be subject to lump sum tax if retained in the fund (e.g. for Centrelink entitlement purposes) or taken as a pension.

In deciding between these two options, the 15 per cent tax on fund earnings should be taken into account, compared to the tax-free fund earnings enjoyed by those in pension phase.

The fund tax will often outweigh the entitlements that could be expected from Centrelink.

However, if the benefit is taken as a lump sum, tax will apply according to a time-based formula.

For example if Tim had 10 years' eligible service at the time of TPD payment and was 15 years from retirement, the calculation would be as follows:

Taxable component of lump sum: $1,500,000 x 10 years/ 25 years = $600,000

Tax (including Medicare) = $600,000 x 22 per cent = $132,000

Grossing up the amount of insurance, so that a net of $1,500,000 was received is calculated as follows: ($1,500,000/ $1,368,000) x $1,500,000 = $1,644,737 (i.e. a gross up factor of 9.65 per cent).

Grossing up the premium = $1,740 x 1.0965 = $1,908

So the before tax cost of super minus $1,908 is still far less than the before tax cost of non-super minus $2,852; plus Tim will be getting an additional $144,737 in life cover (tax-free as mentioned if paid to a tax dependant).

Note: Very few life offices allow the TPD extension to be greater than the life cover, and where they do, the excess TPD cover is usually at stand-alone rates.

Additionally, we have included the life cover in this case study as TPD is rarely provided stand-alone from the life cover.

This is because of the sole purpose test, where the fund must be operated for core or core and ancillary purposes. Disability benefits such as TPD benefits are one of the ancillary purposes of the sole purpose test.

Calculating the optimum amount of TPD cover in super can be done in a number of ways.

Preferred approaches include ‘replacement of income' that would be lost if a client could not work again, allowing an extra amount for superannuation contributions so that the post retirement period was adequately catered for.

This cover would be held alongside income protection cover for a term of, say, five years (rather than age 65 cover), given that someone on a claim for this length of time would most likely be TPD and meet the ‘permanent incapacity' condition of release.

Alternatively, holding income protection to age 65 could mean the amount of TPD cover was adequately catered for by dialling down the amount calculated under the ‘replacement of income' method.

There is some difference of opinion in the industry concerning the interplay of TPD and income protection insurance where it is held in the one super fund.

Some commentators say that the ‘temporary incapacity' definition in the legislation - which states it does not constitute ‘permanent incapacity' - means once the latter condition is met, income protection benefits (i.e. the temporary incapacity pension) must cease.

MLC (and other providers) does not agree with this view as preserved benefits can be paid and continue to be paid once a member meets a condition of release. We do not believe that two forms of protection that naturally complement each other cannot be paid together.

In summary, the Stronger Super changes:

• Have limited the TPD definitions that can be offered in super to ‘any occupation', but many clients only require this definition;
• Do not change the up front and ‘back-end' benefits on claim of holding TPD cover in super; and
• Product innovation has led to solutions whereby super owned ‘any occupation' TPD insurance compliant with Stronger Super can be linked to the more generous ‘own occupation' TPD definition insurance held outside super.

Sean McCormack is the general manager of insurance product and underwriting at NAB Wealth.