There are a wide range of choices that need to be made when setting up an income protection policy and it is important to give due consideration to each of these to ensure that the policy is tailor made to your requirements. The information below covers all of these choices and provides information on what to consider for each.
It might seem like a fairly simple task to work out how much monthly income is required in the event that you are unable to work for a prolonged period. However, it is extremely common to underestimate your monthly outgoings so we recommend taking some time to record your actual spending and you may well be surprised at exactly where your money goes each month.
To assist with this task we have prepared a basic expenditure sheet that you can download and fill out, and this should enable you to produce an accurate record of your spending.
It is very important to note at this point that it is not possible to take a policy that will replace all of your monthly income, with income protection providers allowing you to cover between 50% and 70% of your income for tax and National Insurance deductions. However, income protection payments are non-taxable so it is possible to replace significantly more than 70% of your take home pay, dependent on your level of income. If you were to take out a policy covering a higher percentage of your income than allowed by an insurance company, you should be aware that in the event of a claim they will only pay out up to their maximum permitted limit.
It may be that you do not need to take out the maximum level of cover allowed by the insurer to cover your essential outgoings in which case the sensible approach is to only take as much cover as you require as this will keep the monthly premium to the absolute minimum.
The deferred period is the amount of time that you would be unable to work due to an accident or injury required to trigger monthly benefit payments. Most insurance companies offer deferred periods of 4 weeks, 8 weeks, 13 weeks, 26 weeks or 52 weeks but there is a limited number of insurers that offer deferred periods as short as one week or as long as 104 weeks.
The monthly cost of income protection is heavily affected by the deferred period selected, with cost reducing as the deferred period increases. This is particularly so for deferred periods of up to three months, where premiums can reduce by up to 50% from 4 weeks to 13 weeks deferred but with a much reduced impact from 13 weeks upwards.
So, when you are considering setting the deferred period, the cost is an obvious consideration but you should also a factor in how much sick-pay you get, if any, and how long you could survive financially with any savings that you may have. If you are employed and have a sick pay provision then it is ideal to set the deferred period to match the length of your sick pay, if your budget allows.
If you are self-employed then sick-pay is obviously not relevant and a shorter deferred period therefore has an obvious attraction but also, typically, has a high cost penalty. One possible solution to consider is to take out a policy with longer deferred period than the ideal, with a lower premium, but put the money saved into a rainy day account, which over time, would build up to provide a financial buffer to cover the longer deferred period.
Income protection premiums come in very different types. It is something that is not that obvious when you obtain online quotes of the impact on the overall cost of your policy can be absolutely enormous. There are certain occupations that will not be able to take some of the premium options, with jobs that contain a large element of Manual labour only qualifying for age-costed premiums. The main premium types are as follows.
- Guaranteed premiums
- Reviewable premiums
- Age-costed guaranteed premiums Age-costed reviewable premiums
- Discounted premiums
Guaranteed premiums – a guaranteed premium is fixed for the full term of your cover, other than for an increase in cover amount, and is generally viewed as the best option.
Reviewable premiums – the starting premium is reviewed by the insurance company periodically, typically every five years, which means that the premiums can increase significantly throughout the policy term. They are normally cheaper than guaranteed premiums when the policy is started it can cost more over the full policy length.
Age-costed guaranteed premiums – also known as escalating premiums, the monthly premium increases each year as your age increases, with significant increases through the 50 to 60 years age band. The premium increases are set in a published rate table that cannot be altered and are therefore totally predictable.
Age-costed reviewable premiums – also known as escalating premiums, the monthly premium increases each year as your age increases, with significant increases through the 50 to 60 years age band. The predicted premium increases are set in a published rate table but the insurance company has the option of reviewing that rate table and so the increase is may not be in line with what was suggested. However, history has shown that changes to these reviewable rate tables are extremely rare.
Discounted premiums – there are premiums available that include a significant discount on the assumption that the policy holder will adopt a healthy lifestyle and demonstrate that to the insurer. If this is not done then the policy will increase by small amounts each year as a sort of punishment for not justifying the healthy lifestyle discount. The amount of discount will vary depending on the term of the policy taken out but can be up to 20%
Maximum pay-out period
One of the major choices that needs to be made when taking income protection relates to how long the policy will pay for if you cannot work. In essence, there are two distinct classes of policy, what is commonly termed full income protection verses budget income protection.
Full Term Pay-out Full
income protection will pay out from the end of the deferred period all the way through until the end of the policy term, which could be in excess of 40 years. This is the options and that we recommend as it offers the maximum amount of protection in the event of a claim and when it is considered that the average income protection claim is in the region of 7 years, it is not unreasonable to think that this is the only sort of policy that is fit for purpose.
Short Term Pay-out
Budget income protection will pay out from the end of the deferred period for a set period of time, which is normally anywhere between 2 and 5 years. While it is clearly significantly better to have this type of policy than none at all, it should be viewed as very much a compromise between the amount of cover required and the monthly cost. Budget income protection policies are very approximately around half the cost of the full versions.
If your budget does not allow you to consider full income protection then there are significant details that you need to take into account when choosing your policy. Some a budget income protection policies will allow multiple claims, so that although the maximum pay-out length may be only e.g. 2 years, it may be possible to have combined pay-outs adding up to a much longer amount. Have a budget income protection policies work very differently and simply allow you to make a claim or combined claims up to the maximum allowed e.g. two years, and then no more claims can be made. So even with budget income protection policies, not all policies are equal and if you are considering this option it is likely that the policy allowing multiple claims is a better compromise than one that does not.
How much cover can have?
It is mentioned elsewhere on this website that it is possible to take out an income protection policy that will pay out between 50% and 70% of your gross income. While this is absolutely correct, it may not be possible to easily calculate what this figure is, particularly in the case of self-employed individuals. The reason for this is that insurance companies allow you to cover a maximum percentage of your allowable income, however, the definition of allowable income does vary depending on which insurance company you are dealing with.
It is fair to say that all insurers include basic salary as allowable income but the following income types may or may not be viewed as acceptable.
- Bonus payments
- P11D benefits
- Net profit (sole traders)
If you are considering taking out a policy with as high a benefit level as you can, it is highly recommended to discuss your requirements with an income protection expert, to avoid paying for more cover than you can actually claim on or taking out less cover than you might be able to due to miscalculating your level of allowable income.
Income proof at claim
It is extremely important to be aware that in the event of a claim being made, you will be required to provide documentary evidence of your CURRENT income level and if your income level has fallen since you took out the policy, you may not qualify for the payment amount that you were expecting. If you are in a position where your allowable income is likely to fluctuate, there are two approaches that you can take try and eliminate this potential problem. Firstly, you can regularly review your income level and adjust your level of income protection if necessary. This however, would require a significant amount of effort on a regular basis and the end result may still be that you would have a lower level of income protection cover that you originally took out. The second approach, involves providing documentary evidence of your allowable income at the time that you take your policy out and the insurance company does not require you to prove your income in the event of a claim. For obvious reasons this is a much simpler option and highly recommended if you are in an occupation where your income fluctuates but be aware, only a handful of income protection providers allow you to do this.
Index linking trap
Be aware, that if you take out the maximum allowable percentage of cover and also index link your benefit, unless your income increases at least as much as the increased cover each year you will automatically be exceeding the insurer limits and therefore paying for additional cover that you cannot claim on. Since the ‘credit crunch’ a number of years ago, the salaries of many people have not increased in line with inflation and therefore this is a very real issue so if you are planning to take the maximum allowable amount of cover and also index link your benefit amount you should think very carefully before doing so.
As well as insurers allowing a maximum percentage of income to be protected, they also have limits regarding the absolute maximum amount of cover that they will allow you to take. This limit varies enormously depending on the insurer, with limits from £26,000 per year up to £200,000 per year, though it may be possible to take higher levels of cover under specific circumstances, so speak to an income protection adviser if your requirements are over this nominal limit.