Bruce Brammall, 12 September, 2018, Eureka Report
SUMMARY: Concessional contribution limit reductions have made the call on insurance inside super a tougher decision. Here’s what you need to consider.
Life insurance is a beast that has been smashed from pillar to post in recent times.
Commissions have been demonised and reformed, with more reform likely. ASIC has taken many swipes (including this last week). And the Royal Commission has trashed the reputations of some of the biggest insurers in the industry.
Like any industry, it’s imperfect. Reforms are necessary. Major changes probably required.
But it doesn’t change the base importance of insurance to the individual. It’s an absolutely essential consideration of financial planning, through the cycle of life. And as trustees of self-managed super funds, it’s actually a legal requirement to consider insurance for your members. Which is you.
Yes, SMSFs have a duty to consider insurance for their members. It became enshrined in legislation several years ago.
That doesn’t mean that you have to take out insurance. You must consider it. And review it regularly.
But what is it that you must consider? Essentially, whether your members have needs for insurance and then what you, as trustees, have considered in your decision to take out, or not take out, insurance in the fund.
Why do people need insurance? If they would leave spouses and children behind in the event of their death and there aren’t enough assets for them to survive on. They have significant debts (home loan), or high expenses (kids in private schools, or significant investment debt, for example). Or they have a lifestyle they would like to continue to lead, even in the event of a life-altering accident or condition.
The four life insurances
There are four main types of “life insurance”. They are life, total and permanent disability (TPD), trauma and income protection.
The first three are lump sums, to be paid when certain events occur. Income protection is designed to replace up to 75% of your income, in the event that you are unable to work, due to accident or illness, so is potentially an ongoing payment.
Life insurance is designed to pay out when you’re, well, not alive anymore. You’re covering your spouse and/or children, because you’re not there to financially support them anymore.
Total and permanent disability insurance (TPD) is best to think of as “accident insurance”. You’ve had a major accident and you’re unable to work and this is designed to be a lump sum payment to help you sort your financial life. Potentially, to pay out debts, or to have a lump sum to invest to create a future income stream.
Trauma insurance is also known as “illness” insurance or “recovery” money. Think heart attack, cancer or stroke (though it can cover dozens of other illnesses, depending on the policy). It is designed to give you a sum of money to take the financial pressure off when you need to focus on recovery.
Income protection insurance is designed to replace up to 75% of your income in the event that you can’t work.
But there are some very important strategic and tax considerations to take into account, which makes everyone’s situation different, plus differences relating to age and income
What can/should be covered in super?
Two very different questions, can and should.
What can be covered in super? Simple: Life, TPD and income protection. (Trauma cover cannot be taken inside a super fund.)
The premiums for all three are potentially tax deductible to a super fund. If you have a life/TPD policy inside your super fund that costs you $2000 a year, then that becomes a tax deduction as an expense to the super fund. The net cost would, therefore, be $1700 ($2000 less 15%).
What insurances should you take out in super?
That is far more complex and really requires personal financial advice. It will take into account your age, how much insurance you require, your income and the cost of that insurance. But it may take into account more complex considerations, such as future contributions, contribution limits, net wealth, etc.
For younger Australians or people with smaller insurance requirements, super can be a good place to house their insurance. This is particularly so if they have the flexibility to make extra contributions into super to cover the premiums, which gives them both tax-effective insurance coverage and a tax saving for those super contributions.
But as the needs/costs of insurance rise, more thought needs to be given to taking the insurance outside of super. High insurance premiums can eat heavily into your super fund’s balance, so in many cases, it might be better to organise the insurance in your personal name (where, unfortunately, there is no tax deduction available for Life and TPD).
Why shouldn’t you take the coverage in super?
The reduction in the concessional contribution (CC) limit to $25,000 in 2017 has changed the ball game for insurance in super for many.
Taking life and TPD insurance out in super was almost a no-brainer when contribution limits were higher (at $35,000 or $50,000 or more).
But for those with large insurance requirements or high premiums, the cost of premiums makes it a tougher call as to whether some or all of the insurance should be held inside super and some outside. This becomes a particular issue for those trying to maximise their super with concessional contributions up to the $25,000 limit.
Take a 50-year-old male office worker needing $2 million of life and TPD insurance. They will face around $6000 a year of premiums. This is a “stepped premium”, which will rise considerably in the next 5-10 years. By 55, the cost will be closer to $10,000 a year.
Those premiums are a sizeable chunk of your concessional contributions. Even putting in at $25,000, the cost of $10,000 of premiums leaves only a net $15,000 (or $12,750 after contributions tax) for your retirement.
Note: I will only deal with stepped premiums today. Other options include “level” premiums or unitised cover, which is the cover most often used by industry funds.
Reducing cover and cost as you age
Premiums start to really ramp up in your 50s for stepped premiums. This is because insurance is risk-based and its statistically becoming more likely that an “event” will lead to an insurance payout.
But as you age, your needs for insurance should also start to reduce. Your net assets should be increasing (home loan paid down, home increasing in value, super increasing, investments increasing and, hopefully, debts reducing).
As you age and the premiums start to rise significantly, you can start to reduce the coverage. If your $1 million policy has increased in premiums, you could reduce the coverage of the policy to, say, $750,000, thereby reducing the premiums. And reduce them further, a few more years down the track.
Income protection in super
It has become increasingly difficult to justify income protection (IP) inside super. Life and TPD insurance is a general “yes”, but IP is an “almost never”.
This is mainly because income protection is also a tax deduction outside of super at your marginal tax rate (up to 47%, versus 15% in your super fund). But it has been exacerbated in recent years by the lower CC limits.
The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.
Bruce Brammall is managing director of Bruce Brammall Financial and is both a licensed financial adviser and mortgage broker. E: firstname.lastname@example.org . Bruce’s sixth book, Mortgages Made Easy, is available now.