Income replacement should cover all your needs
This is the second article in a six-part series on getting the most from life assurance, compiled by Personal Finance in assocation with Liberty.
The most important life assurance cover that you, as a working person, should have in place is an income protection policy that will pay you a monthly income if you are disabled.
Your ability to earn an income is your most valuable asset, and the income you earn is likely to be what you will use to accumulate assets such as your home, your car, your savings, and so on.
Every working person – unless you are very wealthy– needs disability cover to protect your income in case you become disabled and are unable to earn a living. Ideally, you should put this type of cover in place when you are young and before you have dependants.
Only once you enter into a relationship and/or have children do you need to consider taking out life cover to provide for dependants.
Although you can buy two kinds of policies to protect your future income – those that pay a lump sum and those that pay a monthly income, known as income replacement policies – the latter kind is usually better.
Most people who have cover against disability have a policy that will pay out a lump sum. Nicholas van der Nest, divisional director for risk products at Liberty, says 80 percent of policies that cover disability pay out a lump sum rather than a monthly income.
One of the reasons many more people have lump sum disability cover, rather than an income replacement policy, is that lump sum benefit policies are often cheaper, Van der Nest says.
The benefits of income replacement policies are also sometimes not well understood, he says.
However, for many people, a policy that will pay a monthly income is the better option, he says.
If you opt for a policy with a lump sum benefit, it will be your responsibility to choose an appropriate level of cover so that if you are disabled and invest the payout, it will provide you with sufficient income for the rest of your life.
To select the right amount, you need to estimate how your future earnings will grow and also how long you may live.
It is very easy to outlive a lump sum, Van der Nest says.
If you have a policy that pays a monthly income, the life assurance company carries the risk of ensuring you are paid each month, and it is more likely that the benefit will be aligned to the income you earned before you became disabled.
If you can afford to buy lump sum cover as well, you could take out cover that will pay off your debts, such as your home loan, or will help you to modify your home or vehicle to suit your disability.
Another reason an income replacement policy could be better is that it can offer cover for a temporary disability or for the period it takes a life assurer to establish whether or not your disability is permanent. This feature could prove invaluable if you have a disability from which you will recover, or one from which you may or may not recover and your life company needs time to assess the permanence of your injury or illness.
Your life assurance company will not pay out a lump sum disability benefit unless your disability is confirmed as permanent. For example, if you contract cancer but there is a chance you may recover after treatment, the cover you have for permanent disabilities will not pay out.
However, if you have an income replacement policy with temporary disability cover, you will be able to claim temporary benefits while the permanence of your disability is being established.
You can usually select the period for which you want the temporary benefits on an income replacement policy – a few weeks or months or even up to two years.
Another benefit of an income replacement policy is that if you are only partially disabled and lose a portion of your income as a result, these policies can supplement the income you continue to earn.
Many people suffer partial permanent disabilities – life assurers say 30 percent of all claims are for partial disabilities.
A partial disability may leave you unable to do the job you were doing before you were disabled – possibly because you are unable to perform at the same level and pace as you did before – but still capable of doing some work.
The payment you receive from a lump sum disability policy will then depend on how your policy defines disability – is your disability defined in terms of your ability to do your own job, your ability to do your own or a similar job, an impairment to a part of your body or body system, or your ability to perform certain activities of daily living?
An income replacement policy, on the other hand, can replace the income you have lost as a result of your disability, regardless of how it is defined.
ADD-ON COVER CAN BE A REAL BENEFIT
Income replacement policies have started to offer benefits you can add to your policy – the premium will be higher but the extra cover could prove to be of value to you.
For example, some policies offer cover for up to a year if your child is diagnosed with a terminal illness. This benefit will enable you to stop working so you can care for your child or pay for a full-time caregiver.
Some policies offer a lump sum that is a multiple of your monthly benefit if any of your dependants – a spouse or a child – is diagnosed with a critical illness.
A benefit that may appeal to women who are starting a family is a maternity benefit that is usually offered without an additional charge. This benefit may entitle you to a “premium holiday” (you don’t have to pay your premiums) while you are on maternity leave, or it pays an amount equal to your premiums.
Some policies offer retrenchment cover that pays you the income benefit for which you are insured for six months if you are retrenched.
Life assurance companies have in the past shied away from offering retrenchment cover. Nicholas van der Nest, divisional director for risk products at Liberty, says Liberty considered all the financial cover you would need over your working life and decided that cover for retrenchment was a big gap in the life assurance market. The average South African is retrenched 1.8 times during his or her working life, he says.
Van der Nest says most people do not insure their full salary on a retrenchment benefit, because this level of cover would be expensive. But Liberty encourages policyholders to take retrenchment cover for their essential needs, such as their home loan, vehicle repayments, school fees, food, and so on.
Business owners and professionals can make use of add-on benefits that pay the overhead expenses of your business or practice should you be unable to pay these as a result of a disability.
In the case of professionals, this benefit can cover the cost of a locum hired to continue your practice while you are disabled and until either you can return to work or you can sell your business.
TERMS AND CONDITIONS YOU SHOULD CHECK
There are some terms you need to watch out for when you buy an income protection policy.
First, your policy will be in place for a certain period. Most policies offer you cover until you are reach the age of 60 or 65, and some have cover to age 70, recognising that people are working longer.
Recently, “whole of life” income replacement policies have been launched, offering you protection against the costs of impairment even after you have retired.
Watch out, though, for cheaper policies that offer you cover until only age 55, when, should you become disabled, you may still be a long way from having accumulated sufficient savings on which to retire.
Fifty-five is the age from which the risk of disability increases, so you may be unable to extend your cover except at a very high cost, because you are now older and pose a greater risk to the life assurance company.
Another term you need to check is that which applies to the payment of the income benefit.
You should ensure that the benefit will be paid until the age at which your retirement savings will be sufficient to provide you with an income.
You need to plan how you will continue to fund your retirement savings in the event that you are disabled. Your options are:
* You pay your retirement fund contributions using the income benefit you will receive if you are disabled;
* You take out lump sum disability cover to provide for your retirement; or
* You take out a premium waiver on a retirement annuity (RA) that will pay your contributions to your RA after you become disabled.
Some life assurance companies believe your income protection needs do not end at retirement, but are different before and after you retire.
Before retirement, you need to protect your human capital – your ability to earn a future income, Nicholas van der Nest, divisional director for risk products at Liberty, says. After retirement, you need to protect your financial capital – your retirement savings.
When you retire, you stop working and no longer face the risk that an injury or an illness will leave you unable to earn an income.
However, you are at risk that an impairment – including losing the ability to perform the activities of daily living – in old age will lead to unforeseen expenses (such as having to employ a nurse or a caregiver to look after you) that will erode your retirement savings. For this reason, life assurance companies now offer a “whole of life” income protection benefit that pays out a percentage of your insured income after retirement, depending on the severity of your impairment. This benefit can be cost-effective if you buy it before you are 45, Van der Nest says.
TAX BREAKS CAN MAKE INCOME REPLACEMENT AFFORDABLE
The premiums on income replacement disability policies may seem more expensive than those on lump sum benefit policies, but remember that income replacement policy premiums are tax-deductible, which lowers the cost to you, whereas the premiums on lump sum benefit policies are not.
The costs of protecting your income are regarded as an expense incurred in generating an income, and the Income Tax Act enables you to claim these costs as a tax deduction, as long as the benefit is paid in the form of a monthly income.
The taxman, in effect, pays a percentage of your contributions, because your contributions reduce your taxable income. If your marginal tax rate is 30 percent (you have an annual income of more than R250 000), you save R30 in tax for every R100 in contributions you pay.
If your premiums are paid from your salary by your employer, your employer can adjust your Pay As You Earn tax to take into account any premiums you pay on an income protection policy. Alternatively, you can claim the deduction on your income tax return and your tax will be adjusted on assessment.
Your life company should send you an income tax certificate that states the amount you can claim against your taxable income.
Because the contributions are tax-deductible, if you are disabled and become entitled to a monthly benefit, you will pay tax on the benefit, but this will be at your marginal tax rate at that time. This is the opposite to lump sum disability insurance, which is not tax-deductible but pays a tax-free benefit on disability.
If you take out an income replacement policy that includes other benefits, such as lump sum disability cover or an investment portion, only the portion of the premium that is used to pay for the income benefit is tax-deductible.
Some life assurers offer a sickness benefit that is not tax-deductible, but the benefits paid out on these policies are tax-free.
However, the maximum percentage of your income that can be insured is lower, usually only about 60 percent of your income.