Disability Cover Options, Moneyweb's Personal Finance Supplement, January 2013

DISABILITY COVER OPTIONS: SHOULD YOU CHOOSE LUMP SUM PAY-OUT IN THE EVENT OF PERMANENT DISABILITY?

Experts in the income protection sector are urging financial advisers and clients to be wary of the inclination towards using lump sum/capital disability (CD) for disability cover.

Some advisers are defaulting towards a lump sum pay-out in the event of permanent disability because their clients are re-assured by the thought of a large amount of capital to tide them over for initial cash-flow demands.

We would not recommend this approach because it does not take into account both the short-term stress of efficiently managing that sudden capital pay-out and the long-term implications for the client’s financial well-being.

This cover is called ‘Income Protection’ for a very good reason and that’s what it primarily must do, protect the client’s income, and the best way to do that is usually to invest in a policy which pays out in monthly instalments for the rest of the individual’s working period.

CD has a role to play in permanent disability cover but the lump sum payment should be utilised for the correct reasons - settling outstanding debts, business assurance, partial contributions towards an investment, preparing for major lifestyle changes as a result of disability - it should not be used to replace future income.
The major problem with planning future income cover using a fixed CD benefit is uncertainty because the CD is not flexible and clients will need to make key assumptions about the potential disability period until their retirement, the effect of inflation on their claim pay-outs, and the expected return on initial lump sum investments made.

Obviously clients are unable to predict if or when they will become disabled and it is therefore difficult to know what period of time would need to be covered until retirement. This might lead to the client being over-insured when investing in a lump sum policy when there are other investments options available that might be more suitable, beneficial, and affordable.

Most clients are better off with a holistic income protection plan, including Temporary Income Protection (TIP) for temporary disability, and a combination of CD and Permanent Income Protection (PIP) for permanent disability.

Not only is PIP less expensive than CD in the long run, but premiums are tax-deductible. PIP pays out monthly income replacement benefits and can be used to cover both permanent and longer temporary disabilities. PIP is specifically designed to match the client’s income over time, with the option of increasing pay-outs in line with inflation. This type of cover is suitable for sustaining the individual’s lifestyle and meeting cash flow requirements.

TIP is also vital because far more clients are likely to experience temporary disability (which could seriously impact on a self-employed person’s income) than are likely to experience permanent disability.
TIP also provides crucial bridging income through the period during which a disability is being diagnosed and verified as permanent (the waiting period).

It is important to understand that CD, PIP, and TIP are different products with different functions and that they should be used in conjunction rather than as replacements for each other. To ensure comprehensive cover for disability, FMI advocates a holistic approach that combines TIP, CD, and PIP drawing on the strength of each product to ensure comprehensive cover for disability in the long term.