Income Replacement Benefits versus Lump Sum Disability Benefits

“Is an Income Replacement benefit more appropriate than a Lump Sum Disability benefit?” is a question increasingly being asked in financial services’ circles.

Speaking at a recent Risk Seminar, a representative of a leading Reassurance company made the point that South Africa is at odds with most of the developed markets where Lump Sum Disability benefits are not sold. He argued that an Income Replacement benefit is more appropriate since it can exactly match the needs of the client – ‘Replacement of Income’.

This article takes the debate further by objectively examining the benefits of each option.

The case for Income Replacement Benefits

o The amount of cover can be closely matched to the exact income needs of the client

Income Replacement benefits are designed to replace any loss in income a client suffers due to disability during their normal working life. So long as the client’s cover is reviewed and updated on a regular basis, the benefit payments should closely match their normal income at the time of disablement.

These payments are guaranteed to the client’s normal retirement age (or other age the client selected) and will keep pace with inflation (assuming this option was selected by the client).

Whilst it is possible to achieve the same result with a Lump Sum benefit, a whole host of assumptions have to be made - specifically about future investment returns, inflation and how long the benefit will be required. In all likelihood there will be a mismatch.

o Temporary disability is automatically covered

Unlike Lump Sum Disability benefits that only pay out on permanent disability, the Income Replacement benefit will be paid for temporary periods of disability also. This is a key advantage since an extended period of temporary disability could have a devastating impact on a client’s financial well-being.

Of course a client could take out separate temporary disability cover on top of a Lump Sum Disability benefit and thereby have full protection against temporary and permanent disability. However, this could be a substantially more expensive way of achieving what the one Income Replacement plan provides.

o There are significant tax advantages

Premiums on Income Replacement benefits are tax deductible but not so for Lump Sum Disability benefits. Although the proceeds are taxable, whereas they are not on Lump Sum Disability benefits, in the event of a claim the client has benefited from a deferment of tax. Further, in the situations where no disability claim is made, the Receiver has effectively funded 40% (or whatever the client’s marginal tax rate is) of the “insurance” cost.

The Case for Lump Sum Disability Benefits

o Loss of income is not necessarily a condition of payment

Unlike Income Replacement benefits which will only pay out (a maximum of) the actual loss in income, Lump Sum Disability benefits will pay out even when there is no loss of income. Consider the example of an executive who, despite losing both her legs in a car accident, can continue to perform her normal duties. An Income Replacement benefit would pay nothing whereas a Lump Sum Disability Benefit would pay out the full sum assured.

o The value of the benefit does not reduce as the client approaches retirement age

With Income Replacement benefits the maximum total payment reduces as the client gets older. For example, consider a client with Income Replacement cover to age 65 who becomes permanently disabled at age 55. They will receive a monthly income payment for the remaining 10 years - 120 payments in all. But should the disability occur at age 60 they would receive only 60 payments. With a Lump Sum Disability benefit, the payment at age 55 and 60 would be the same (ignoring inflationary increases in cover).

o The benefit can be used to settle debt

Becoming permanently disabled is likely to put many people on an emotional rollercoaster and for many, getting rid of debt will become a priority. Only the Lump Sum Disability option can achieve this.

o Unused benefits are preserved in the event of death after disability

Unlike Income Replacement benefits where payments will cease on death, the lump sum disability benefit can be invested to secure income payments after the death of the client.

o Business assurance

There are several applications in business assurance where only Lump Sum Disability benefits can provide the appropriate cover.

The Cost Comparison

There is a perception in the market that Income Replacement Benefits are more expensive than the Lump Sum benefits – this is not the case.

In practice it is actually quite difficult to compare the cost of each because the benefit payments and conditions thereof are structured very differently. However, we can do some indicative comparisons to get a sense of the relative cost of each.

Let’s take the example of Mr. X who will turn 40 at next birthday. He earns R60000 per month and requires income replacement cover to age 65 in the event of becoming permanently disabled.

Although typically he would only be able to insure up to 75% of this income with any one company, we’ll assume that he can insure 100% of it – by taking insurance of 75% with one company and 25% with another. Bear in mind that aggregation only takes place if the total cover amount exceeds 100% of his normal earnings at claim stage.

We will assume that the tax on income and rebates on premiums are offset against each other and so will be ignored for the purposes of the example.

The normal Income Replacement benefit automatically includes cover for temporary disability so in an attempt to exclude this from the benefit we will select a waiting period of 24 months.

The premium for this income insurance is around R1 044 per month (using current rates).

For this premium, Mr. X would be able to get about R4.4 million Lump Sum Disability cover.

This lump sum would purchase a monthly income of around R24 000 at age 40 for a term of 25 years (assuming an average investment return of 9% and an annual increase in income of 5%). In other words, if Mr. X should become permanently disabled immediately after taking the benefit, the Income Replacement option would have been the better option (in hindsight).

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In fact, it isn’t until about age 58, under this scenario, that the Lump Sum Disability benefit appears to produce a higher income. (See graph below).

However, bear in mind also that under this scenario, the Lump Sum Disability Benefit will pay once permanent disability is confirmed, whereas there will be a waiting period of 24 months under the Income Replacement Benefit.

One might argue that investing the proceeds in an investment linked structure should yield a substantially better income than the guaranteed structure we have assumed for our calculations and therefore the Lump Sum Disability benefit is a better option. Indeed it is this precise argument that has led to the shift in client preference from the conventional guaranteed life annuity to the Investment Linked Life annuity.

Another argument often put forward is that life expectancy after the event giving rise to the disability might be shortened, so that assuming that payments will continue to retirement age (65 in this example) is overly optimistic and overstates what will be paid on an Income Replacement benefit. In fact, based on information provided by Gen Re, the average life expectancy after a disability claim is about eight years.

Assuming then that, on average, the Lump Sum Disability payment need only provide income for eight years, it will provide an income very close to that of the Income Replacement benefit (see illustration below).

However, whilst life companies can use “averages” within a large pool of individuals, it would be extremely unwise to base financial decisions for one person on these averages.

 (Click on image to enlarge)

After all, Mr. X is not Mr. Average and it is highly unlikely that his life expectancy will match that of “Mr. Average”.

Conclusion

Income Replacement benefits and Lump Sum benefits both have an important role in financial planning.

An Income Replacement benefit is likely to be the most cost effective solution for the client when the primary need is for replacement of income.

Lump Sum benefits, on the other hand, are better suited to settling debt and for various business assurance applications.