When should income protection cover be held inside superannuation?

When it comes to income protection, clients’ individual circumstances will dictate whether that cover is held inside or outside of superannuation. TAL's David Glen weighs up the options between the two.

Every working Australian has a one in three chance of becoming disabled for more than three months before reaching retirement age (Actuaries Australia, 2000), and the statistics clearly illustrate the importance of covering what is, for most people, their most valuable asset – their ability to earn an income.

Indeed, at TAL Retail Life we paid out more than $165 million in income protection claims in 2011 alone, which demonstrates just how much security income protection insurance can provide.

But while most advisers recognise the importance of income protection, one of the most frequent questions I am asked as I meet planners around the country is whether the policies should be held inside or outside super.

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Of course, there is no easy answer – what is best for each client depends on that client’s individual circumstances.

But the ability of financial advisers to provide the sound advice to enable clients to make an informed choice is crucial.

Weighing up the options

Whether income protection is held inside or outside super, some key features remain the same:

• Both structures can offer tax deductibility for the cost of cover;
• Recipients are taxed at their marginal rates on receipt of benefits under both structures; and
• After-tax cost of income protection cover is the same under both structures.

But there are some key (and complex) differences, which mean that it can be a crucial decision for advisers to help clients make.

The most obvious advantage to taking out a policy within super is that there is no impact on the client’s day-to-day cash flow.

Clients can use the 9 per cent superannuation guarantee contribution, or accumulated superannuation balances, to finance the cost of income protection cover.

Nevertheless, purchasing insurance through super can pose significant disadvantages for some people.

A real issue for many is that super contributions to fund income protection cover are included in the concessional contribution cap, which has now been set at $25,000 per year.

Insurance in super can erode this cap – which can lead to potentially serious consequences, particularly for older clients.

In addition, the trustee must comply with trust deed and Superannuation Industry Supervision Act (1993) requirements where the income protection is held through super, which results in a greater compliance burden.

The trustee has to meet the requirements of the temporary incapacity condition of release before the income protection benefit can be paid to the member whereas, outside super, the insured person only has to comply with the terms of the insurance contract.

Another factor to consider is that benefits through super are limited to a non-commutable income stream in substitution for the income the member was receiving before incapacity.

This means that certain ancillary benefits such as the childcare benefit or needle stick injury benefit (increasingly popular with medical workers) cannot be offered by a superannuation fund.

And ancillary benefits can be particularly problematic in a self-managed super fund (SMSF), where there may be a possible contravention of the sole purpose test, risking the benefit being locked in the SMSF.

Clients should be made aware that the receipt of total and permanent disability (TPD) benefits outside of super at the same time as income protection benefits within super may create difficulties.

TPD benefits are paid on permanent incapacity, while income protection benefits are payable on temporary incapacity only.

The concepts of permanent and temporary incapacity are mutually exclusive.

A member is either permanently or temporarily incapacitated. 

In some situations, the agreed value contract of the policy may result in entitlements greater than pre-disability income. In this case, the excess would be retained by the super fund.

This presents particular difficulties for clients with fluctuating incomes. 

This risk can be cushioned by the so-called 75 per cent rule (the life insurance industry generally limits income protection benefits to 75 per cent of an individual’s pre-incapacity income).

Therefore, the compensation received from the income protection policy topped up with ancillary benefits may not reach 100 per cent of pre-disability income.

For policies held within super, the conditions of release allow payment of 100 per cent of pre-disability income and no more.

Making the right choice

The best approach for purchasing income protection insurance will depend on the varying requirements of each client.

For clients with sufficient cash flows, such as professionals or tradespeople, income protection outside superannuation is likely to be the better option.

Similarly, clients close to the peak of their earning capacity, and ‘empty nesters,’ for whom the priority should be increasing their retirement savings by contributing the maximum amount to super, should consider purchasing income protection outside super.

Meanwhile, clients with uncertain cash flow (such as people starting a new business) or younger families with plenty of working years ahead but tight finances at present, might be better off insuring their incomes through super.

Those for whom a ‘vanilla’ product (without ancillary benefits) would suffice might also find insurance through super easier and more efficient.

This is a complex area for consumers to navigate alone so the expert advice of a professional adviser is key. 

It’s also crucial for advisers to explain to their clients the benefit of regularly reviewing their cover together. As we know, what’s appropriate for a client now may not fit the bill in two, five or 10 years time.

This is where the value of a long-term relationship with a qualified financial planner really comes into its own.

David Glen is a tax counsel at TAL.