Income replacement benefits: Are they REALLY expensive?

There is a perception that income replacement benefits are expensive relative to lump sum disability benefits. A look at the real cost of income protection reveals a different picture.

The factor that probably contributes most to the perception that income replacement benefits are 'expensive' is that the lump sum benefits, against which they are compared, are simply too small to allow for a valid comparison. This invalid basis for comparison comes about because clients tend to overestimate the income that a lump sum will generate. A lump sum of say R1 million may sound like a lot of money, but how much income can it really generate over the same term as an income replacement benefit, especially where that income must keep pace with inflation ?

Comparison

The following table illustrates the lump sum disability amount that will generate the same income as an income replacement benefit of R10 000 per month, with annual claim escalation linked to inflation, over different terms.

Term to income replacement benefit expiry          Equivalent lump sum disability benefit amount
                        35 years                                                         R2.6 million
                        25 years                                                         R2.1 million
                        15 years                                                         R1.4 million
                        10 years                                                         R1 million
                                Assumptions: Inflation 5%; investment return 8%

When comparing premiums of income replacement benefits to those of lump sum disability benefits, one should use a longer waiting period on the income benefit. This allows for the fact that the lump sum benefits do not cover temporary disability.

On an income benefit with a six-month waiting period, the premiums are on average 50% lower than the premiums of the equivalent lump sum benefits as shown in the table above. The comparison was based on stand-alone own occupation lump sum disability benefit quotes from all of the major life companies.

Cost effective

The cost effectiveness of income replacement benefits increases further, when one considers the tax deductibility of premiums. Premiums on lump sum benefits are not tax deductible while the proceeds are tax free. However, where the client uses a lump sum to generate an income, he is likely to end up paying some tax anyway.

Suitable protection

A client could argue that he would need less than the equivalent lump sum benefit used in the comparison above, as he may not have long to live once he is permanently disabled. However, since the client does not know how long he is going to live, this would not be a prudent assumption.

The point should be made that many clients may not be able to self-insure against income lost on temporary disability. So, a lump sum disability benefit on its own would not be in their best interest, as it only covers permanent and not temporary disability. Income replacement benefits on the other hand cover both. It is this fact that often makes them the most suitable way in which to protect a client's income.

All things considered

Income replacement benefits and lump sum disability benefits both have a place in financial planning. Lump sum benefits provide a cost effective way to settle debt. Income benefits are generally best suited for income protection. The perception of income replacement benefits being expensive is unfounded - one has to consider the true cost of each in providing a comprehensive solution.