Underinsurance: a mug’s game

Probably the single biggest issue facing a financial planner when sitting down with a client is the discussion about the allocation of often limited financial resources. That is, how much can the client afford and how much are they willing to pay/invest.

In the back of the client’s mind is generally a cap or upper limit on how much money there is to invest or spend on life insurance — the so-called ‘point of pain’.

The challenge is for the planner to work around that cap and come up with the best overall result for the client — that is, to ensure they have the right strategy to build and protect the client’s wealth, and at the right price.

Often, the reality is that the client’s upper limit is well below what is required.

The existence of the ‘point of pain’ is clearly responsible in part for the high levels of under-saving and underinsurance in the Australian community today.

There are, of course, many other factors, but this is a very good place to start.

In life insurance, consumers often do not get the full and proper cover they require because they are reluctant to pay for the complete suite of protection they need.

A matter of priorities

In investments, clients are often reluctant to commit what they should because of competing spending priorities. These are pretty much the same thing. There are also plenty of other more desirable things to spend money on now rather than life insurance or saving for the future.

This was highlighted in 2005 when the Federal Government began a Parliamentary Inquiry into how to encourage people under 40 to save more for their retirement. Earlier this year that report was finalised and circulated. Unfortunately it came out after the May Federal Budget, where significant changes to superannuation were announced, so the inquiry’s discussions and recommendations were often overlooked.

Most of the submissions to the inquiry and the recommendations that followed were along traditional lines.

Under-40s were to be encouraged to save more through education, awareness, removal of taxes on super contributions and so on.

But no one really dealt with the fact that most people under 40 have limited financial resources. They have competing demands for their income.

For example, under-40s usually have relatively large mortgages, are running two cars, have young kids at school and may even still have HECS liabilities.

In fact, HECS is probably a little recognised factor in the home affordability debate of today.

For under-40s, finding the extra dollar to put into superannuation is not a high priority.

Buying life insurance at this stage of life is also often not a high priority when, considering the level of debt and other financial commitments, it clearly should be. And at that stage of life, with young families, the risk of financial suffering is at its near peak.

The conflict between need and financial commitment for under-40s is perhaps highlighted by recent Finsia research, which found that around half of those under 40 recognised the need for retirement saving, but only about a third of the age group were actually doing anything about it.

This is despite the fact that most people still think they will be self-funded retirees and not have to rely on the pension in later life.

Waiting for an inheritance seems to be the answer to some, although anecdotal evidence indicates that their parents — the Baby Boomers — are determined to spend most of it.

Tower, in its submission to the inquiry, sought to highlight the issue of competing financial demands and suggested that to encourage people under 40 to think more about saving for retirement there had to be a link between what is a high priority (that is, the mortgage) and what is often a low spending priority (that is, saving for retirement).

It was suggested that perhaps people under 40 should receive a mortgage interest rate tax benefit if they put more into super over and above the 9 per cent statutory requirement.

This mortgage — super saving tax trade-off suggestion was noted by the inquiry as being different to all others and definitely a little more creative in thought, but it was not taken up in their final list of recommendations.

Never mind, it is an idea that is now ‘out there’ and may resurface in the future.

The need to deal with the allocation of scarce financial resources and get over the ‘point of pain’ has been on our mind at Tower this November.

Okay, this is probably a bit of a whimsical approach to the issue and it doesn’t mean that Tower has become a ‘wowser’ in terms of personal lifestyles, but here are some interesting thoughts. There are also some hard messages in what follows.

November is traditionally Australia’s biggest gambling month. The Melbourne Cup sees big dollars put on horses as just about everyone has a little ‘flutter’. And for many Australians, the flutter on the cup amounts to their one big gambling event for the year.

However, there is the broad perception that Australia is a gambling nation, reflected by the often-quoted saying that ‘Australians will bet on two flies crawling up a wall’.

The fact that Australians are gamblers is probably also highlighted by the existence of the underinsurance gap.

Clearly, most Australians are prepared to gamble that nothing wrong is going to happen to them so they will remain financially sound throughout life. Also, by not saving enough, they are gambling on their retirement.

It might be a bit harsh to say it, but for some it really is gambling with their financial future.

But there appears to be a bit of a paradox at play in Australia as a gambling nation.

For many, a day at the races is about gambling for fun and profit. But for others, putting money on lotteries and Lotto is not gambling for fun, but is seen as a way to unearned wealth and being able to quit work and retire to a lifestyle of luxury.

The ‘windfall sea change’

This is one of the great Australian dreams perhaps. But the bad news is the odds are definitely against it, so for most it will remain just a dream.

According to the Australian Bureau of Statistics, every man, woman and child in Australia spends around $15 to $20 a week gambling, whether it be lotteries, ‘scratchies’, a day at the races, Lotto or the poker machines. Not everyone gambles, but for the sake of this exercise let’s work with the $20 a week figure.

Firstly, there is definitely no shortage of ways to gamble in Australia.

Total annual spending on gambling in this country in 2004-05 was nearly $16 billion. It is probably above that level now.

The good news in all of this is that governments indirectly take a large slice in terms of taxes, and this helps fund services that would have to be paid for directly by personal taxes. A bit of cross-subsidisation that works in some respects.

But there are other ways for Australians to get richer.

It might not be as quick, but the odds are better and the returns are often much greater. And this is where the financial planner comes in — helping sell the concept of long-term wealth creation and protection, despite the client’s professed limited resources.

Hope is not a plan

Long-term wealth can be a lot more assured than relying on the hope of short-term gain.

For example, in raw number terms, if say $10 of that $20 a week presently spent on gambling was invested in a superannuation fund returning 6 per cent over 30 years, the added savings at the end would be approximately $42,300.

Investing $15 a week extra delivers nearly $63,500 and, if the full $20 a week is put into the system, then retirement savings will be up by more than $85,000.

That additional amount will provide a better retirement outcome for the investor, especially when it is in addition to what will be accumulated through compulsory superannuation.

That $10 a week can be added into super at a 15 per cent tax rate (for pre-tax contributions) while gambling must be funded fully out of post-tax dollars. That is, to have $20 dollars a week to spend on gambling, the average person at a marginal tax rate of 30 per cent must have first earned around $28.

With $10 going into super pre-tax, the remaining $10 comes out of around $14 post-tax dollars. The investor is two-ways better off.

So by saving $10 a week over 35 years the investor could get a large tax-free payout of $42,300 at age 60 under the proposed new super rules.

Battling the odds

There are not many wins in Lotto or at the races of that size even if the winnings are tax-free.

But the odds are also definitely in the investor’s favour.

The odds of winning the lottery are about 100,000 to one. Winning on the ‘scratchies’ is around the same if not longer.

Of winning Lotto (that is, getting six numbers right out of 42), the calculation is the following multiplication: 42x41x40x39x38x37 = ?

Sorry, but the average desktop calculator doesn’t have enough zeros to put that number into context. Let’s just say it is several tens of million to one.

The odds of winning at the racetrack may be considerably shorter, but the chances of winning big dollars without a big risk are also slim.

There are not many instances of punters walking away from the track or the off-course tote with enough to retire on without first taking a big, big risk.

There are more well-off bookmakers than well-off gamblers. And those well-off gamblers usually had a large stake to start with.

Yet, Australians are seemingly prone to take the biggest risk with the things they probably cannot afford to, their health and financial wellbeing.

Australia has a huge underinsurance gap. If a person suffers a debilitating disease or cannot work for a substantial period of time the wealth they have accumulated over time can quickly disappear. For many, it can mean financial hardship for them and their families.

And the odds of suffering a serious or debilitating illness are a lot shorter than most wagering choices.

For example, the odds of winning a Powerball game are put at around one in 55 million, and the monthly cost is around $61.10.

Income protection is a better bet

However, the odds of suffering an injury or illness that leads to three months or more off work are one in three.

To gain protection in that circumstance (that is, a $5,000 a month income protection policy), the monthly cost would be around $66 (agreed value standard policy, payable to age 65, for a 35-year-old white collar professional).

Some more disturbing ‘odds’ for you to consider courtesy of the Australian Government.

The chance of a male contracting cancer before the age 75 is one in three, for a female it’s one in four. The chance of a 40-year-old getting coronary heart disease in the future is one in two for males and one in three for females.

Yes, it seems Australia is a nation of gamblers. Unfortunately, they appear to be partly gambling on the wrong things — their working life, financial wellbeing and the level of financial security they will have in retirement.

The client doesn’t have to totally give up their weekly play on lotto or the pools or even a day at the track — they just might win big and you may have to offer them a completely different financial advice service.

But when it comes to allocating those scarce resources, some gambles are just not worth the risk. The client could lose big-time.

Carly O’Keefe is a superannuation adviser for Tower Investment.