When developing a financial plan, people have a tendency to focus on the exciting stuff – how much they’re going to invest, what they’re going to invest into and how will that compound over time to create financial independence. But what about when things go wrong?
A good financial plan should include risk mitigation strategies built in for when things don’t go to plan. One element of the risk mitigation strategy is Income Protection.
While you are on the journey to achieve financial independence, your ability to earn an income is your greatest asset. It is the tool which gives you the capacity to save, invest and cover living expenses.
Despite this, it’s amazing how many people insure their homes, cars, pets and even phones, but aren’t willing to insure their biggest asset that pays for all these things – their income!
In this article we are going to bring more awareness to Income Protection so you can better understand what it is and how it works.
What is Income Protection?
Income Protection, called ‘Salary Continuance’, is an insurance policy that provides a monthly benefit if you are unable to work due to accident, illness or injury. You might be thinking, “isn’t that what workers compensation is for?” No, there’s a difference.
Workers compensation is a policy taken out by your employer which covers you (as an employee) if you are injured at work or become sick due to your work. If you have an accident, illness or injury unrelated to your work, workers compensation won’t pay out in that event, but Income Protection would.
The primary components of an Income Protection policy are the monthly benefit, waiting period and benefit period. Let’s discuss each of these components in detail.
Monthly Benefit
The monthly benefit is your sum insured. It is the amount of money that you will receive in the event of a claim.
The maximum monthly benefit you can apply for is 70% of your gross annual income. For example, if you earn $100,000 per year, your maximum monthly benefit is $5,833.
You don’t have to apply for the maximum amount, you can reduce it to only what you need. For instance, if your maximum monthly insured amount is $5,833 but you only need $4,000 per month to cover basic living costs, you might choose to reduce your sum insured to $4,700 per month.
The reason we didn’t suggest a $4,000 per month benefit (in line with expenses) is because the monthly benefit is taxable. You need to factor in tax payable on the benefit and consider how much you will be left with after-tax.
Waiting Period
The waiting period is how long you need to be off work for before you can make a claim on the policy. You can generally get a waiting period between 14 days and 2 years, in set increments.
The shorter your waiting period, the more expensive your cover will be. Given this, you need to make consideration as to what length waiting period is appropriate for your situation.
For example, if you have an emergency fund in place that will cover living expenses for up to 3 months, you may want to opt for a 90-day waiting period. You may also want to factor in accrued annual leave and sick leave which will be paid out if you are unable to work.
Just as a word of caution, be careful when you are applying for an extended waiting period due to accrued annual leave and sick leave. If you leave your employer, and lose your entitlements, you can’t reduce your waiting period without going through medical underwriting. We will discuss medical underwriting in more detail later.
Also, the monthly benefit is paid in arrears (at the end of the month). This means that if you have a 30-day wait, your first payment would be made 60 days after you ceased work.
Benefit Period
The benefit period is how long your policy will continue paying for if you are unable to work. This can range anywhere from 2 years up to age 70, in set increments (most insurers cap the maximum benefit period at age 65).
The longer your waiting period, the more expensive your cover will be. Given this, you need to make consideration as to what length benefit period is appropriate for your situation.
For example, if you have an Income Protection policy with a 30-day waiting period and a benefit payable to age 65, this means you would need to be off work for 30 days before you can make a claim and it would continue providing a monthly benefit up to age 65 if you were unable to return to work (subject to ongoing requirements being met).
There are some instances where you may want to reduce your benefit period in order to reduce your premium. For example, if you are 35 and you are on track to achieve financial independence by age 40, you may want to opt for a 5-year benefit if your income isn’t needed beyond that point.
Structuring your Income Protection
You have the option to structure your Income Protection inside super or outside of superannuation.
If you choose to structure your Income Protection inside super, the premium will come out of your super fund. Conversely, if you choose to structure your Income Protection outside super, the premium will be payable by you personally.
Cashflow permitting, we often suggest Income Protection policies are structured outside of super as it is a tax-deductible expense. For example, if you are on the top marginal tax bracket of 47% (inc. Medicare levy) and your Income Protection premium is $2,000 per year, the net cost of the cover after factoring in the tax benefit is only $1,060 per annum.
On the other hand, if you fund the same premium via super, your super fund claims a tax deduction at the super rate of 15%, giving you a higher net cost at $1,700 per annum.
If your cash flow is tight, it is better to structure your Income Protection inside super rather than not have cover. But remember, if you can’t afford Income Protection then you also can’t afford not to have it.
How much does cover cost?
The cost of your Income Protection is going to vary depending on a number of factors including age, gender, occupation, smoking status and policy benefits.
With regards to occupation, if you have a sedentary occupation, you can expect to pay a less than someone with a manual occupation. This is because an injury is more likely to prevent you working in a manual occupation.
For instance, when I tore my ACL and had surgery on it, I didn’t need to claim on my Income Protection because I have the capacity to sit all day. It didn’t affect my ability to work. If I was a tradesman, and on my feet all day, I would have been off work for months and would have needed to claim on the policy.
All insurers price their occupation categories slightly differently so it is important to shop your cover around to find a good deal.
Stepped vs level premium
You generally have the option to apply for a stepped or a level premium. A stepped premium will increase in cost as you get older. A level premium will cost more initially but won’t increase as a result of age.
We typically don’t like level premiums because insurance fills a short-term need. It is there to protect you while you are building your net asset position. As your net asset position grows, you should require less cover, which means that over time you can consider increasing the waiting period, reducing the benefit period or reducing the monthly sum insured. Given this, why would you pay more to lock in cover which hopefully won’t be needed for the long term?
Also, insurance companies are notorious for increasing level premiums as a result of product repricing, and the insurer that is the best in marketplace for you now, might not be the best in a couple of years and you may look to switch.
Taking into consideration all of the above, we typically don’t suggest a level premium however every scenario is different and can be justification in certain circumstances.
Applying for cover
There are two general categories of Income Protection – group insurance and retail insurance. I would highly recommend you opt for retail insurance.
A group insurance policy is a form of pooled insurance arrangement which is offered by most super funds. Generally speaking, the benefits and options offered through group insurance are restrictive.
A retail product on the other hand, allows you greater flexibility to tailor the cover to your situation and your requirements. For many low-risk occupations, a retail policy is also often cheaper.
Importantly, a retail policy will be medically underwritten at time of application. This process does take longer than cover that is not underwritten, but results in far greater certainty for you at claim time.
To get a retail policy I would suggest you speak with a Financial Adviser. As advisers we have access to insurance products that you can’t get directly. Also, your Adviser can provide guidance on how much cover you need and ensure it is structured tax effectively.
If you don’t have an Adviser, and would like our help, see Personal Insurance. You can get the process started online.
The underwriting process
The underwriting process involves a series of questions about your medical history. This is normally done either with your adviser or with the insurer directly via a tele-interview.
Generally, there are no mandatory medical tests as part of an application (unless you have a large sum insured) however, further investigations may be required dependent on your medical history. This could include obtaining a medical report from your doctor or requesting specific test/investigations be done.
If you have a pre-existing medical condition, the insurer may put a loading or exclusion on your policy. A loading is an increased premium, and an exclusion is an event where the policy wouldn’t pay. Let me give you an example of an exclusion.
Both of my shoulders have torn labrums and there is a very good chance that I will need to have surgery on my shoulders at some point in the future. If I were to apply for an Income Protection policy now, I would likely have my shoulders excluded because it’s a pre-existing condition. This means, if I did have surgery on my shoulders, and was off work as a result, I wouldn’t be able to claim on my Income Protection.
However, let’s say I was in a car accident and my shoulder got ripped out due to the force of impact. In this instance, the cause of the injury was not my existing condition it was the force of the car accident. Given this, I would still be able to claim on the policy.
If you do get an exclusion placed on your policy, ensure you read the wording of the exclusion carefully to fully understand when you are and aren’t covered.
It is a lot easier to go through the underwriting process when you are younger and have had little to no pre-existing medical conditions. I did this myself, in my early 20s, and I have Income Protection with no loadings or exclusions, so my shoulders are covered!
There is a term in the insurance world called “clean-skin”. This basically means that you can answer “no” to all the underwriting questions, the policy goes in-force immediately without any loadings or exclusions. If possible, it’s good to get cover early on in your working career while you are still a clean-skin.
APRA Changes to Income Protection
Not all Income Protection policies are the same. Due to increasing cost of premiums, APRA made some industry wide changes which impacted the features available under an Income Protection policy. The changes occurred 1 April 2020 and 1 October 2021.
Policies attained after 1 April 2020 can no longer have an ‘agreed’ monthly benefit. All new policies are now indemnity only.
Policies attained after 1 October 2021 have the following restrictions:
- Income replacement ratio restricted to 70% of income (excluding superannuation), This was previously up to 75% of income, including superannuation;
- Ancillary benefits in the first six months of a claim to be restricted to an additional 20% of income, i.e. a limit of 90% overall. Previously, comprehensive cover could offer up to double the benefit during this period;
- Indemnity definition of Pre-Disability Income to be calculated over the 12 months leading up to claim. Previously, definitions could use the highest 12 months income in the last 2 or 3 years to reduce the impact of fluctuating income; and
- After 2 or 5 years on claim (dependent on the policy), the return to work assessment analysis changes from “Own Occupation” to “Any Occupation”. Previously, it was an “own occupation” definition for the entire benefit period.
Given the changes, the older Income Protection policies are actually better! But they are also more expensive and insurers are tending continue increasing the price. If you do have existing cover, and are thinking about moving, just be aware of what you will lose.
Guided Investors take
Your ability to earn an income is fundamental in the wealth creation process and, by extension, Income Protection is too. Given this, we include Income Protection as part of our ‘financial housekeeping’ in Stage 1 of Wealth Creation; Building your Financial Foundation. Don’t be that person whose house burns down and they don’t have home insurance.
