DIY super: don’t let life cover take a back seat

The gentle rumble that was self-managed super has grown into a resounding roar over the past few years.

I guess it’s for all the right reasons — a sense of control, the perception of flexibility, a need for power in decision-making, all leading to larger retirement caches, we hope.

The path to self-managed super funds (SMSFs) has been cleared too, by advisers becoming more educated about how to assist clients in this specialised area of advice. The downside of this is that at times it seems all the focus is only on the fund as the be-all and end-all.

Warning bells

There is a casualty of this rising popularity and focus, and there is therefore a need to ring some warning bells around an otherwise good news story.

Asset protection in the form of life insurance, and to a lesser extent total and permanent disability (TPD) and income protection, has been thrown out with the bathwater, so to speak.

Life insurance, which accompanies super in industry and employer funds, is not always adequate, but even if inadequate at best it raises awareness and engenders acceptance of insurance and at worst it enforces some cover on an otherwise underinsured population.

I do concede that some clients haven’t got a clue what insurance they do have either in terms of the amount or in the type of cover. Advisers have a responsibility to improve education in this area, and I’m not sure this is happening as a part of the SMSF advice process.

Insurance shortfall

The Australian Taxation Office (ATO) tells us that underfunding is an issue, given that the average SMSF member account balance is in the order of $250,000. Add this to the average amount of death cover in Australia, at around $140,000 according to the Investment and Financial Services Association (IFSA), and there is a chronic and continuing shortfall in funding.

The very structure inherent in insurance-in-super is counterproductive to optimal total funding, considering that insurance premiums are generally paid out of account balances. This has a significant effect on retirement funding as the insured life gets older and more expensive in terms of premium per dollar of sum insured.

Much has been said about the pros and cons of insurance in super, so we won’t go there. Nor do I need to revisit the technical limits and rules that an adviser must keep an eye on.

So let’s look at why people buy insurance, and consider where insurance fits with self-managed super in the light of those reasons.

Estate planning

People buy the various forms of life insurance as estate planning tools, whether they realise it or not. Estate planning at its simplest implies:

n asking the client what they want to happen if they die tomorrow with all their worldly wealth as well as their worldly debts;

n calculating if they have sufficient funds to fulfil those wishes, right here and now;

n structuring a solution to any funding shortfall — insurance is the most cost-effective;

n identifying if they have adequate instructions recorded and mechanisms in place to make those wishes come true, right here and now; and

n structuring a solution to guarantee distribution of wealth and removal of debt as desired. Superannuation nominations and wills with their various mechanisms such as testamentary trusts, as well as the insurance policy ownership structures, will achieve this.

The principles are the same whether the client is a business or a family or both.

Handling all the tasks that emerge from this analysis is a combined effort, probably between four professionals in the main — risk adviser, investment adviser (sometimes one and the same if they have the resources), lawyer and accountant.

But ironically the funding, taken care of by the risk adviser, is the pivotal point of the whole process. The rest of the advice counts for nothing unless the money is there when it is due to be used and distributed.

The bigger picture

Setting up an SMSF should be just a part of this estate planning process.

In truth, however, the fund is likely to be driven in the short-term by either super choice or a disillusionment with investment returns, and a desire for control and the perception of savings on fees and commissions.

This serves to focus the client and the adviser on these aims, rather than the depth of need of full estate planning. Within this context, it is not surprising that insurance takes a back seat. It may not even get raised at all within the SMSF implementation discussion.

It should be a concern for any professional involved in the setting up of a SMSF, to coach the clients on the breadth and depth of issues they should be considering. This clearly must include the question of holding insurance within the fund — or not — and how much to have in total.

What benefits do clients perceive they gain from having their own fund and do these benefits transpose to the insurance side of the planning equation? And what do advisers need to understand about the implications for insurance, of the client’s perceptions of self-managed super?

Flexibility and choice

Depending on what the clients invest in, they will have more flexibility to adapt and restructure and re-weight and take up timely and diversified investment opportunities.

No such advantages attach to the purchase of insurance within a SMSF. Retail products are all that are available. This means the insurance decision need not be a difficult one and, in fact, is akin to a commodity purchase, once the correct needs analysis has identified the sums insured required.

Accessibility

There is a certain ‘comfort’ clients gain from the perception they are able to almost touch and feel their superannuation assets rather than the distance of holding managed funds.

Clients may also perceive that insurance benefits paid into an SMSF are easier to access than from an arms-length fund. Not so, of course, but it is imperative the advice they are given is very clear in relation to issues of access.

Most crucial are the requirements for payout of TPD, terminal illness and trauma benefits. Regardless of the trusteeship, the Superannuation Industry Supervision (SIS) definitions are still the bottom line and having their own fund does not circumvent these rules.

Price considerations

Fees and commissions are often perceived to be the evil of intermediated super fund management. But the real cost of audit and accounting leads the skilled adviser to nevertheless advise against SMSFs for clients with initial balances that cannot justify those attendant costs.

Without debating that fees and commissions are justified, we have to concede that for those with sufficient funds an SMSF can be a cost-effective exercise.

So it is somewhat of a dilemma that a client moving from, say, an employer fund will forfeit the common advantage of lower-than-retail insurance premiums. Once they choose to structure their own fund they are subject to individual premium rates and on substantial sums insured this can be quite an impost.

One size does not fit all

Most employer funds structure insurance in tiers, with the most cover given to executives, while other employee tiers are covered by a lower formula. Thus, for example, top management may enjoy seven times salary, middle management five times salary and the factory or store floor staff two times wages.

It is vital the SMSF adviser stresses that there is little correlation between the one-size-fits-all cover of the employer fund, and the realistic and accurate needs analysis the adviser will conduct for the family.

Only that part of the cover appropriate to place into super should be put into the SMSF, with the end goal clearly in mind — to address all of the needs rather than let the fund drive the outcome.

Client insurability

If a client has a health problem and is in an employer fund that has afforded them the benefit of automatic acceptance, they may be substantially disadvantaged by opting out of that fund.

Continuations may not apply to a voluntary move out of the employer fund, so their new insurance application for the SMSF puts the client back on the baseline as far as underwriting is concerned.

This may mean being offered the new policy at a loaded premium, or at worst being declined. The underwriting therefore must be completed if possible before the old fund is abandoned.

Policy ownership

It is the trustee entity or the trustees who own the insurances.

Thus, if a company with mum and dad directors is the trustee of the fund, it is also the owner of the insurance policies on all members.

The entry of a new member, such as one of the children, will dictate the child also becomes a director of the trustee company and their insurance will also be owned by the company as trustee. There is no change required to the insurance policy ownership of the parents’ policies, however, as the company is still the company.

If the SMSF has individual trustees mum and dad, and the child becomes a member of the fund as well as a trustee, the child therefore in turn becomes a third owner of the existing insurance in their capacity as a trustee. The change in insurance policy ownership leads to administration hassles.

This is, therefore, a significant factor in the selection of the trustee structure of the fund. And if the super fund adviser considers this a moot point in the scheme of things, be aware the Australian Taxation Office has become very pedantic about the clear identification of ownership of all assets in SMSFs, including insurance policies. The timely change of ownership is therefore crucial.

Self-managed super has many benefits. While taking advantage of those benefits, however, it is crucial that the total estate planning and insurance needs not be pushed into the background in the flurry of activity around setting up the fund.

Sue Laing is principal of Laing Advisory Services. She can be contacted at [email protected].