There is a minor but growing trend, particularly among newer life assurance companies, to provide life policies that pay out a death benefit as an ongoing income, rather than a once-off lump sum.
The move is being hailed by some, but one of the new assurers, AltRisk, says uncertainty about how an income benefit will be taxed has limited financial advisers’ interest in this option (see “The tax question”, below).
Recently, FMI, a life assurer in the Lombard Group, launched a life policy that, it claims, offers more flexibility to structure the benefit to meet the income needs of your dependants and provide a lump sum for once-off expenses, such as paying off a mortgage bond.
FMI has until now focused on providing income protection policies that replace your income if you become disabled and are unable to earn an income.
Nic Smit, a product actuary at FMI, says that, in the same way that the best cover for disability is the combination of an ongoing income from an income protection policy and lump sum cover, life cover should be a combination of an ongoing income for your dependants and a lump sum.
Altrisk’s income benefit on its life policies allows you to choose a basic income benefit, which is paid to your beneficiaries for 24 months after your death, or an extended income benefit, which is paid until you, the life assured, would have reached the age of 60, 65 or 70.
BrightRock, another insurer in the Lombard Group, offers the beneficiaries of its life policies the option at claim stage to convert a lump-sum death benefit to an income benefit.
BrightRock’s actuary and director, Schalk Malan, says although BrightRock believes there is value in offering an income as a benefit, it is of the view that your beneficiaries should have a choice when the benefit becomes payable, because the lump sum may be more attractive at that stage. This would be the case if interest rates were rising, because the investment could buy a higher income when rates have risen, or if the beneficiary has a short life expectancy, he says.
If on your death your beneficiaries choose an income rather than a lump sum, BrightRock will use the lump sum to buy a voluntary annuity.
FMI’s policies give you the option to choose different income levels and payment periods to suit the needs of your beneficiaries. So, for example, you could set the lump-sum cover so that it pays off your home loan and then have three income benefits that pay your spouse, your children and a dependent parent.
The income can be linked to inflation and paid for a term – for example, until your spouse reaches the age of retirement – or for the rest of the beneficiary’s life – for example, until your parent dies.
FMI says that, when you take out lump-sum cover to provide for an income need, the amount of cover you buy is based on assumptions about inflation and investment returns that may turn out to be incorrect, resulting in your being under- or over-insured.
In addition, it says, your dependants have to invest and manage a lump sum so that it will provide them with an income. This exposes your dependants to the risk that their needs will not be met if the investment does not perform well, they live longer than expected or inflation is higher than expected and the investment returns do not beat inflation.
FMI says another big advantage of an income benefit is that the benefit becomes cheaper to provide as time passes and less income is required, whereas the lump sum remains the same, and the cost of providing the full lump sum on the day you die is higher than the cost of paying an income from that day onwards. As a result, FMI says, the premiums on its policies may be cheaper and the premium increases may be lower than on a policy that will pay out a lump-sum benefit.
FMI has found that the cost of providing for your disability needs with a lump sum, rather than a monthly income, is between 32 percent and 41 percent higher because of the risks associated with using a lump sum to provide an income stream.
The launch of FMI’s “income for life” policies is likely to spark debate on the merits of an income benefit as opposed to a lump-sum benefit for life cover.
Independent financial adviser Debbie Netto-Jonker of Netto Invest says she is delighted that life assurers are starting to offer income benefits rather than just lump-sum benefits.
An income benefit is likely to provide better protection for widows and orphans, because many people cannot afford the financial advice needed to invest a lump sum to ensure that it will provide for their dependants’ needs, she says.
Before you take out any life assurance policy, you should find out what the exclusions are and ask the cost of the premium per R10 000 of cover, Netto-Jonker says.
Rick Briers-Danks, an independent financial adviser with Veritas Wealth, agrees that an income benefit combined with a lump-sum benefit to pay off debt removes the risks associated with receiving a large cash payout.
You should check whether the premiums will, in fact, be cheaper, and the premium escalations, Briers-Danks says.
An income-benefit policy may be more suitable if your financial planning is “once-off”, he says, but someone who obtains regular financial advice is less likely to get the lump-sum calculation wrong, and an adviser will help the surviving family to invest a lump sum.
Although an income benefit provides certainty about the income your dependants will receive, it removes the flexibility your dependants have to invest a lump sum as they would like to provide for whatever needs arise in the future.
Ryan Chegwidden, the executive head of product at Altrisk, says if the payment of the income benefit is deemed an asset in your estate, a lump-sum benefit should be used to pay the tax.
Malan says that, with BrightRock’s life policies, you are informed what lump-sum benefit your policy will provide on death, as well as the amount of income the lump sum would buy at the date of the statement. The benefit value is guaranteed.
The value of the income benefit that FMI provides will diminish over time. The life assurer will convert an income benefit into a lump sum if the intended beneficiary dies before you do, but the value of the lump sum will be calculated when that event happens, based on assumptions of what that income would have been worth at the time of the beneficiary’s death.
THE TAX QUESTION
FMI believes the income benefit from its life policies will be tax-free from March 1 next year. It says this will be the result of a change to the Income Tax Act that takes effect from that date.
The amendment is intended to harmonise the tax treatment of income replacement policies that pay out an income on disability with the taxation of life and disability policies that pay out a lump sum.
The premiums on a life or disability policy that pays a lump sum are not tax-deductible, but the payout if you claim is tax-free.
You can deduct from your taxable income the premiums on an income replacement policy, but the ongoing annuity (pension) paid out if you become disabled is usually taxed.
The amendment to the Income Tax Act will from next year mean that you will no longer be able to deduct from your taxable income the premiums paid on an income replacement policy, but if you claim on the policy, the income will be tax-free.
Nic Smit, a product actuary at FMI, says that, from March 1, 2015, the Income Tax Act will exempt any amount you or your beneficiaries receive from an insurance policy for death, disability, severe illness or unemployment. He says KPMG has said this exemption will cover the proceeds of such policies, whether paid in the form of an income or a lump sum.
Ryan Chegwidden, the executive head of product at Altrisk, says Altrisk’s income benefit is paid to beneficiaries tax-free. He is of the view that this is because Altrisk’s benefit is paid for a fixed period (until what would have been the retirement age of the life assured).
When an income benefit is paid for an uncertain period, the change to the Income Tax Act that becomes effective next year may bring more clarity, he says.
Schalk Malan, a director and actuary at BrightRock, says BrightRock’s income benefit is taxed as a voluntary annuity: the capital you invested is repaid tax-free and only the interest is taxed.
He says there is still some uncertainty on the implications of the Income Tax Act change that will become effective next year.
COVER YOU ENJOY FROM DIFFERENT BENEFIT OPTIONS
FMI uses the following example to show the difference between its life policy income benefit and a lump-sum policy.
Two 40-year-old men, Tim and Freddy, each earn R60 000 a month, have a wife aged 35, children aged five and eight, and a dependent mother aged 70. Each man also has a home loan of R2 million.
Each man wants to provide an income of R20 000 a month for his wife, R8 000 a month for his mother and R5 000 a month for each of his children.
Tim insures his life for a lump sum of R11.6 million, for a premium of R3 038 a month. Tim’s family will have to use the lump sum to pay off the home loan and invest the balance to provide an income. The policy term is the whole of Tim’s life.
Freddy chooses a policy with different terms that will provide a lump sum of R2 million for the whole of his life and an income of R20 000 a month for his wife until he would have retired at age 65, when the couple would have been able to access their retirement savings. Freddy also wants the benefit to pay his mother an income of R8 000 a month for as long as she lives and R5 000 a month to each child until they turn 24. The cover costs him R2 646 a month.
The premiums and benefits of Tim’s and Freddy’s policies will increase by five percent a year. If Freddy dies while the cover is in place, his beneficiaries’ income will increase by inflation, as measured by the consumer price index, to a maximum of 10 percent a year.
Two years after Tim and Freddy take out their policies, there is an economic downturn, resulting in lower returns from South African equities.
The assumptions that were used to calculate the lump sum required to meet the needs of Tim’s family are no longer correct, and he is under-insured. Tim should have life cover of R13.4 million, but he has only R12.6 million.
If Tim tries to increase his cover and his health has deteriorated, he will have to pay a loading on the additional cover.
Freddy’s cover remains appropriate and so his cover is unaffected by any problems with his health.