Insurance

Is a short payment term acceptable?

Steve Wright discusses income and mortgage protection term lengths and when a shorter term may be a good solution.

The payment term, the length of time a monthly disability insurance policy, like income protection or mortgage repayment insurance, will pay monthly benefits if you are disabled, is often something a client can select. Payment terms range from very short like six, 12 and 24 months; to medium term, five years; or long-term, to age 65 and sometimes even to age 70. Longer payment terms mean potentially higher claim benefits and accordingly, higher premium, so there can be an incentive to select a shorter payment term to reduce premium. Is this a safe strategy?

If one looks at the statistics, it seems pretty clear that most disability claims are of relatively short duration, less than two years, so it might seem like a safe option to recommend a short payment term.

However, there are some important issues to consider.

1. As usual, the client’s particular circumstances and needs, their financial position, their age and anticipated remaining years in the workforce and so on, all need to be carefully considered in order to make a sensible recommendation. All things being equal, shorter payment terms are likely more suitable for clients with relatively few years to retirement than they are for clients just starting their working lives.

2. Although many, maybe even most, clients will not experience long-term or permanent disability, some unlucky clients will – and no one knows who these unlucky clients are until it happens. The financial costs of never being able to work again are massive, the loss of income alone is likely to be a seven-figure amount for most, even those on modest incomes. Loss of such a magnitude invariably requires suitable and adequate protection. The table below shows the aggregate value (to the nearest thousand) over time, of an income lost to disability, by a 30-year-old, indexed by 5% (assuming they get annual increases of 5%).

Yes, that is more than five million dollars over 35 years to retirement age (65) and indexation at 5% makes up $3,319,000 of this, so indexing disability benefits is critically important!

I personally could not imagine bringing a desperate, severely disabled, and still relatively young client the proverbial “last cheque” after a payment term of two or five years ends, knowing how much they will have lost. What does a disabled client do once their short payment term (and their disability benefit) ends? How will such clients survive financially? Can they drag themselves out to perform some job? What if they can’t?

3. If premium cost is a driving feature, can a longer wait period solve the concern? A longer wait period may be more survivable than a short payment term.

4. Does the client fully understand the consequences of a short payment term? I would recommend showing them actual figures to give them the full potential financial consequences.

I’ve heard it said that if a client is disabled for longer than two years they are probably totally and permanently disabled and that some lump-sum TPD cover tacked onto a short payment term will do the job. Well, I’ve not seen any statistics to confirm that, and no doubt some clients may well be totally and permanently disabled, but some may not. Regardless, the cost of the very large lump-sum TPD cover sum insured that would be needed to make up the income lost due to short payment terms would probably cost more than the premium saving of the short payment term. And payment of the lump-sum TPD cover is by no means certain even after a shorter payment term expires because the client may not be totally or permanently disabled.

Some products allow for fixed payment terms to reset on subsequent disability, allowing the shorter 12-month, two-year and five-year, payment terms to “reset”, meaning the full payment term is again available for subsequent periods of disability. Here there are several things to check and consider.

1. Does the payment term reset at all for new periods of disability caused by a condition for which disability benefits were previously paid, or is it only the unused portion of the payment term remaining (if any) that is available for benefit payments on subsequent disability?

2. If payment terms are reset for new or recurrent disability causes, what is the “stand-down” period that applies between periods of disability (during which the client must no longer be disabled) before the payment term is reset in full?

3. A “reset” only applies to subsequent and separate periods of disability. A reset benefit is of no consequence to a client who remains continuously disabled over time.

As with most things, any actions that result in reduced premium will have consequences. Properly understanding these consequences is necessary for making suitable recommendations, and properly explaining these consequences to clients is necessary for ensuring they understand your recommendation and have enough information to make an informed decision. ✚

Steve Wright has qualifications in Law, Economics, Tax and Financial Planning and is General Manager Professional Development at Partners Life.

This article is for information purposes only, its content is intended to be of a general nature, does not take into account your circumstances, situation or goals, and is not a personalised financial adviser service or legal advice. It is recommended you seek advice from a suitably qualified professional before you take any action or rely on anything stated herein.