The value of income protection

A typical Australian with a 40-year working life between the ages of 25 to 65 will earn more than $2.2 million. But sometimes life can be unpredictable, leaving us in situations that we did not foresee and hence did not plan for. The ability to work and make money is not something that should be taken for granted. This is when income protection cover can give you peace of mind.

It is estimated that one in three Australians will be off work due to illness or injury for a continuous period of three months or more during their working life. However, lots of families experience significant financial difficulty, with no income for more than three months. Income protection insurance allows individuals to continue to receive an income even if they are too sick or injured to perform their normal occupation.

Income protection policies can pay a maximum of 75 per cent of the insured’s pre-disability income, with optional ancillary benefits, which may boost this figure to a maximum of 90 per cent of pre-disability income. In addition, the cost of the premium is generally deductible against their assessable income.

Cover in or out of super?

Scenario: John is a 35-year-old electrician working for ABC Electrical Pty Ltd. John earns a $110,000 salary plus super contributions. He and his wife have a $300,000 mortgage for which they pay $2,105 monthly, and a car lease with repayments of $500 per month.

John wishes to understand whether he should have his income protection inside super or outside super, so he seeks the help of a professional financial adviser.

Figure 1 outlines the two options open to John. It also shows which one would be most cost effective for him. For John, having income protection outside super leaves him in a better financial situation. In this example, by paying income protection outside super, more money goes to investment within superannuation, and although there is less cash in-hand after premium payments, the total net benefit is greater.

John decides to plan for the unexpected and take income protection outside of his super.

Accidents can happen

One weekend, John falls and severely twists his knee. After obtaining medical advice, he undergoes a knee reconstruction. John cannot work for four months while his knee is recovering. His private health insurance has been able to cover most of the medical costs, but what about the income that John will lose due to his inability to work for the four months?

Fortunately, he had taken out an income protection policy, which covers 75 per cent of his after expenses earnings with a 30-day waiting period. This includes the full $110,000 generated through his personal exertion and amounts to a monthly income (benefit) of $6,875.

As suggested by his financial adviser, John also took out an accident option, which meant the insurer would pay him one-thirtieth of his benefit for each day that he was totally disabled (if he were disabled for at least three days in a row during his waiting period).

Since John satisfied this definition, he was able to receive the full $6,875 after the first month of total disability and a total of $27,500 for the four months he was off work. The real value of this to John would be the ability to pay his mortgage and his lease payments, and to maintain the family’s lifestyle while he was disabled. John was also able to insure his business expenses while he was disabled.

Value for money

Should John have suffered a more severe disability, his lost income until the age of 65 (assuming an inflation factor of 3 per cent per annum) would be just under $3.5 million. The amount of income protection that could be paid to John in the same period is just over $2.5 million. This amount would be paid over and above any other insurance he has for total and permanent disability or critical illness.

If John took a guaranteed agreed value policy, and he was totally disabled, his income protection benefit would be payable regardless of the following situations:

• A change in occupation;
• A reduction in income; or
• A change in sporting activities or pastimes, or even periods of leave or unemployment.

In addition, John’s income protection premiums would be tax deductible.

In John’s case, his after-tax annual premium would be less than 2 per cent of his gross income after business expenses. This premium would be at blue-collar occupation rates, and would be significantly less if it were for a white-collar professional applicant. In addition, John could save money by taking cover at level premium rates rather than stepped premium rates (the premiums do increase with age in either case), which would initially be more expensive, but could provide considerable cost savings in the long term.

Michael Browne is head of marketing at CommInsure.