The removal of the tax deduction for premiums paid on income protection policies and the increasing flexibility in how you opt to receive disability benefits have re-ignited the debate over whether you should take your benefit as a lump sum or an income.
Lump-sum disability cover may pay out when you are unable to perform certain activities (functional impairment), but the impact of the impairment on your ability to do your job will dictate whether you qualify for a payout on a policy that defines your disability in terms of your occupation.
Income protection is a form of disability cover that pays an ongoing income only, not a lump sum.
In March this year, the tax deduction for income protection premiums was removed, while the income you receive from such a policy if you are disabled and your claim is successful was made tax-free. Until March, the premiums were tax-deductible, but the income after a successful claim was taxed at your marginal tax rate.
The change in legislation has made income protection slightly more expensive, because the premium tax-deduction was at your highest marginal rate, whereas the benefit was taxed by applying the different marginal tax-rate bands to the payout, Nic Smit, the product actuary at life assurer FMI, says.
As a result of the tax change, you may be over-insured if you took out income protection to cover your full pre-tax income, because tax will no longer be deducted from income paid on the claim.
If you are disabled and claim successfully on an income protection policy, most life assurers will not pay you an income that is more than what you earned before you were disabled.
In light of the tax change, life assurance companies and financial advisers have been contacting income protection policyholders and recommending that they check their cover. Some policyholders who are over-insured are being offered the opportunity to convert some of their income benefit to a lump-sum benefit.
Nicholas van der Nest, the director of risk product innovation at Liberty, says about 25 to 30 percent of Liberty’s policyholders were over-insured and were given the opportunity until the end of August to convert the amount by which they were over-insured to lump-sum cover, with R100 000 of lump- sum cover offered for each R1 000 of converted monthly income.
The premiums for the lump-sum cover are based on age.
Van der Nest says there has been a decline in the sales of income protection policies. Although this is in part a result of policyholders requiring lower levels of cover, because the income will no longer be taxed, it is likely that the tax change has made some advisers uncertain about the product.
Financial advisers are likely to be less inclined to sell income protection, because they are having to review all their clients’ cover and may in some cases face having commission paid on policies sold being clawed back, he says.
But at a recent conference organised by Glacier at Sanlam, Dr Eric Starke, the senior medical adviser for Sanlam, said Sanlam’s statistics show that claims paid for lump-sum disability declined from 2011 to 2014. In comparison, claims paid on income protection policies and, in particular, sickness benefits, which cover shorter periods when you are too sick to work, increased hugely over the same period, he says.
Sanlam has been focusing on making people aware of the need for income protection, and this has resulted in its sales of income protection exceeding those for lump-sum cover in the past four to five months, he says.
Starke says you must have cover for temporary disability, and you cannot use lump-sum cover for this.
He is of the view that income protection is the best cover for your income needs, but if you do use lump-sum cover, you must also take out income protection for temporary disability.
Smit also believes that cover that provides ongoing income payments best suits your need to replace lost income if you are disabled. If you have lump-sum cover only, you are at risk of living longer than the lump sum can generate an income. He says there is also the risk that the invested lump sum will not earn good returns and ensure that your income keeps up with inflation.
GREATER FLEXIBILITY IN HOW YOU TAKE YOUR BENEFITS
Life companies are offering greater flexibility in how you are paid disability benefits, which, together with the potential need to adjust the level of cover because of changes to the tax laws, may result in you having to rethink your income and lump-sum needs.
Some life companies now offer you the option of converting a lump-sum benefit to an income when you claim on a disability policy, and recently one life assurer started offering its policyholders the option of converting an income protection benefit to a lump sum.
BrightRock offers policyholders who are permanently disabled the choice at claims stage of taking their benefit as a lump sum or an ongoing income.
The company has highlighted the unfairness of paying for lump-sum cover that increases annually, which assurers price to be in place for your entire working life, whereas you are likely to cancel much of the cover well before you reach retirement.
Recently, Momentum introduced a feature on its Myriad income protection policies that enables you annually to choose to commute all or part (25, 50 or 75 percent) of your income benefit for the following year to a lump sum. This can be done from the second anniversary of your policy once your disability has been confirmed as permanent.
BrightRock’s product actuary and director, Schalk Malan, says a policy that pays your benefit as an income is the best way to protect your income. However, he says financial advisers are also aware that income protection may offer poor value if you do not live for long after becoming disabled.
Consumers have traditionally preferred lump-sum disability cover to income protection, and re-insurers’ statistics have highlighted that only about 18 percent of all disability cover is income protection, he says.
The short life expectancies of people with disabilities can potentially mean that your income protection benefit is less valuable than if you received your entire benefit as a lump sum, he says.
Many of the causes of disability are severe illnesses, such as heart conditions and cancers, that leave policyholders with significantly shorter life expectancies. Lifestyle changes are making these illnesses more prevalent, Malan says.
If you have the choice of receiving your benefit as either a lump sum or an income, you can ensure that your financial needs, whatever they may be when you are disabled, are met, he says.
If your life expectancy following an event that leaves you disabled is short, you can choose the lump-sum benefit, but if you are likely to live a long life, you can choose to receive a regular income.
The removal of the tax deduction for income protection premiums may increase the flexibility to choose the type of benefit you want when you are disabled, because lump-sum and income benefits are now treated the same from a tax point of view, making it easier to substitute one for the other.
Momentum says the feature on its Myriad policies that allows you to commute a year’s income to a lump sum acknowledges that you may need the flexibility of having a lump sum, instead of an income, to cover expenses that result from permanent disability.
Neil Muller, the head of retail life insurance product development at Momentum, says giving policyholders a choice of how they want to receive the proceeds of their policies strikes a balance between the need for an ongoing income and lump-sum payments for once-off expenses.
Muller says the Myriad range now includes a longevity protector for employees who have group health insurance. This benefit gives you protection if you live a long time, because it pays out a lump-sum benefit every five years from the inception of the policy, which you can use to meet lifestyle-related or medical expenses.
If you do not claim on the policy, the longevity benefit is converted to a lump-sum benefit and paid to you when you turn 80, he says.
Not everyone agrees that having the flexibility to choose benefits at claims stage is good.
Nicholas van der Nest, the director of risk product innovation at Liberty, says if you are given a choice between a monthly income and a lump sum when you are disabled, you may not make the most appropriate choice. You might be feeling vulnerable and are likely to choose the lump sum, because this might seem to have greater value than the income, he says.
You should have both lump-sum cover and income protection, and you should correctly establish your need for both when you take out the cover, Van der Nest says.
Nic Smit, the product actuary at FMI, agrees that not everyone will have the discipline to make the right decision and may sacrifice their long-term security for an immediate benefit.
He says lump sums should be used for once-off expenses, such as settling debt and lifestyle changes necessitated by your disability, whereas income benefits should provide you with an income until you retire.
FMI recently extended its income protection benefits to people who often do not qualify for this cover – the likes of game rangers, actors, writers, musicians and oil-rig workers.
Smit says the advantage of income protection over cover for functional impairment is that you do not have to prove you are permanently disabled before an income protection policy will pay out.