Income protection inside super

A major life insurer advised that in 2012, approximately 22 per cent of all retail income protection policies were written under superannuation ownership. By 2014, 50 per cent were being written in this manner.

In the past, it has been difficult to understand why any adviser would want to place their client’s IP within the superannuation environment, the only sound reasoning being a lack of “affordability” to pay the premiums from the client’s after-tax dollars.

With the advent of ‘linked’ policy options it has become very easy to offer clients an IP policy inside of ‘super’, whilst delivering valuable ‘standard’ policy benefits that are not permitted under ‘super’ ownership as well as ‘plus' or ‘premier’ policy features and benefits, all outside of ‘super’.

Not all life offices offer the linked approach for IP, but I’m sure all 11 ‘retail product offer’ life companies will do so before year end.

For those advisers choosing not to provide linked IP and who simply place IP under super ownership, you are doing so at your clients’ and your own peril.

There is a mistaken belief that any ‘standard’ IP policy offered by the life offices can sit easily under ‘super’ ownership. This is not true, as there is no such thing as a ‘standard’ retail IP policy. All 11 retail IP providers have a differing range of benefits included or excluded from their 'standard' policy contracts.

It is also assumed that a ‘standard’ retail life office IP policy with an ‘indemnity’ wording will sit nicely under ‘super’ ownership. And that by association an ‘agreed value’ policy can’t. The latter is correct, the former not.

As we know, SIS Act provisions include a ‘sole purpose’ test and ‘conditions of release’. With regards to IP it is important to understand Regulation 4.07D. Any income protection policies offering benefits inconsistent with the Temporary Incapacity Condition of Release are prohibited.

We would also know that ‘indemnity’ worded contracts differ from ‘agreed’ when calculating the amount of benefit entitlement. ‘Agreed’ is mostly based on the immediate past two or three years prior to commencement of the policy or the start of the waiting period of the policy, whichever favours the insured. ‘Indemnity’ is based on the two or three years immediately prior to commencement of the waiting period only.

However, under superannuation ownership the benefit entitlement is determined in the 12 months immediately prior to the person becoming ‘temporarily incapacitated’. Hence a ‘standard indemnity’ worded IP policy does NOT meet the necessary release condition. When the claims case manager is assessing your client’s proof of income under a ‘super’ IP policy, they can only do so based on the immediate past 12 months.

Under the sole purpose test, IP is considered to be an ‘ancillary’ benefit and as such it does not meet a ‘core purpose’ under the SIS provisions. It therefore cannot be written as ‘stand-alone’ under superannuation ownership. It must be offered with death or retirement benefits.

Very importantly, the above does not apply to pre-1 July 2014 issued IP policy contracts. Great care needs to be taken if an adviser is considering ‘replacing’ such a policy post-30 June 2014.

A little understood consideration when placing IP ownership under ‘super’ is payment of PAYG tax. When an IP policy is owned by the life insured the amount of insured benefit paid at claim is “gross” before tax.

The individual needs to be made aware that they will have to make provision for payment of the appropriate level of PAYG tax as part of the relevant financial year in which they receipted the benefits.

ASIC is expecting the above to be clearly documented in all adviser SOAs. Some SOAs I have sighted in my auditing role do not clearly point this out.

Unless the client clearly understands and ostensibly agrees to taking on the responsibility for payment of the PAYG tax, it leaves the adviser open to a future challenge should a complaint ever arise.

Within ‘super’ ownership the onus of paying the PAYG tax goes to the fund trustees. As such, any IP entitlement paid from a ‘super’ fund must be received net of tax in the hands of the insured person.

I find the above is not well understood by SMSF trustees or the accountants advising them.

IP under ‘super’ ownership must be payable only as an income stream to meet the ‘temporary incapacity’ condition of release.

Should the insured person become ‘permanently incapacitated’, what happens? The insured can no longer receive an ‘income stream’ as they are no longer deemed to be ‘temporarily incapacitated’.

Outside of ‘super’, an IP claimant can receive an IP benefit and [in most cases] a TPD benefit without one offsetting the other. Inside of ‘super’, the member is either ‘temporarily’ or “permanently” incapacitated. They cannot be both!

In closing, a major life office retail product provider took a sample client claim where the insured person, after a one-month waiting period, qualified for a total payment of 6 months' benefit amounting to $30,000 [6 x $5,000 per month]. That is, a seven-month total disability claim event.

If the policy had been owned under 'super' the member would have received $30,000.

Using the given life office product outside of 'super', the very same 'standard' policy could have provided a total of $52,000 [with the 'standard' features not allowed under 'super' ownership].

Using the given life office’s 'plus' or 'premier' policy wording, a maximum of $114,000 could have been payable under the very same claim circumstances, albeit in the worst case scenario.

The lesson we need to learn is that if 'affordability' is the primary process behind your client’s decision to place their IP cover under superannuation ownership, please ensure it is done so on a 'linked' basis, demonstrating you have acted in your client’s best interests.

Placing any IP policy under 'super' ownership post-30 June 2014 without linking it will expose the adviser to potential adverse consequences, either at claim or audit time, or both.

Philip Smith is a director of Dawes Smith & Partners