The ideals of Life Insurance have been forgotten with lies, greed and malfeasance transforming what was once “the noblest enterprise” into a scheme to enrich agents and management over the customers. One bought life insurance to provide protection for your dependents. But that did not allow the policyholder to reap a benefit during their lifetime. To allow this, an endless number of ancillary products have been grafted onto the basic life Insurance policies degrading the entire industry and making the sale of “life Insurance” more attractive and therefore easier for the salesman.
When establishing your Self Managed Superannuation Fund the structure and registration of the fund with the regulators is a prescriptive process. The key and arguably most important step however, is the formulation, documenting and implementing a unique Investment Strategy.
What is an SMSF’s Investment Strategy
Superannuation law requires a SMSF to have an investment strategy. The Superannuation Industry Supervision Act requires that an Investment Strategy is formulated, reviewed regularly and given effect to. The investment strategy has regard to the all the circumstances of the fund covering the following;
- the risk involved in making, holding and realising, the fund’s investments, having regard to its objectives
- its expected cash flow requirements the likely return from investments
- the composition of the fund’s investments including the extent to which the investments are diverse or involve the fund in being exposed to risks from inadequate diversification;
- the liquidity of the fund’s investments, having regard to its expected cash flow requirements;
- the ability of the fund to discharge its existing and prospective liabilities
Discipline and commitment to the Strategy is needed
“A successful lifelong investment experience hinges on three critical steps: the development of a prudent investment plan, the full implementation of that plan, and the discipline to maintain the plan in good times and bad. If you create a good plan and follow it, your probability of financial freedom increases exponentially.”
All about Asset Allocation: by Richard A. Ferri, CFA
This paragraph highlights that the implementation and maintaining the investments strategy is key. That the SMSF legislation requires trustees to have a written strategy is beneficial as with a written plan one is more likely to follow it. One should read the strategy regularly especially at the time of making investment decisions.
Discussing the subject of life insurance raises anything from confusion to disgruntlement for those considering taking the product. Unsatisfactory experiences with Life Insurance have too frequently made the news telling of an impact that is truly heartbreaking. The impact of these life changing circumstances and misfortune that are recounted is only magnified when a resulting insurance claim is rejected. Is this the reason for the low ownership of life insurance or under-insurance in Australia?
Life insurance agents will advise of the benefits of using an agent that are particularly useful at the time of a claim. That underinsurance remains unresolved and is widely spoken about means that the consumer is not convinced of the benefits of Life Insurance and is deeply suspicions of this noble product. Is the reason for this caused by the behaviour of the Life Insurance industry, or is the lack of understanding of the need for and mechanics of life insurance the contributing factor?
Improving knowledge and understanding of the product is considered key to getting the most out of Life Insurance as a wise consumer.
Understanding Life Insurance
Life insurance is one of the products where the beneficiary of the service is not the person who makes the purchase. Thus, on a standard life insurance policy, the policy-holder is unable to realise a direct benefit during their lifetime. Ancillary products have however, been grafted onto the standard Life Insurance policy, to overcome this perceived shortcoming. This makes the sale of “Life Insurance” more attractive and therefore easier, for the salesman. The broader coverage added to life insurance, allows one to benefit during one’s lifetime, beyond the normal ideals of life insurance. This enhances the perceived benefit to the policy-holder but gives rise to other complications for the industry and leads to disputes.
In 2016, an industry-wide review of claims handling in the Australian Life Insurance Industry was carried out. This indicated that a claims decline rate of 4% for Life Insurance with higher rejection rates for Income Protection, Trauma and Disability where rejection rates were higher, on average between 7% and 16%. Insurance Industry dispute data indicates 50% of all disputes about policy definitions are for TPD and pre-existing health conditions, with the rest about specific conditions such as cancer, heart attack and stroke. Medical advancement has rendered defined life events such as heart attack, stroke and cancer out of date or not comprehensive enough to cover every scenario. The result is insurers either declining claims. Alternatively, being traumatic circumstances claims are paid on an ex-gratia or goodwill basis, and, policyholders may receive payment despite sustaining minimal or no loss or impact. The ex-gratia payments are borne by the general body of policyholders resulting in an uplift of Life Insurance costs for the general body of policy-holders.
The poor image of the insurance industry thus comes from the poor experiences of a small proportion of policyholders that has been compounded by insurance coverage being expanded beyond life insurance products providing benefits at death only.
The result is that life insurance is shunned, the preference being to assume that the basic level of insurance within superannuation provides adequately. However, the provision of a basic sum insured, not tailored to member’s individual needs, could only result in disenchantment. It’s necessary to develop a basic understanding of life insurance to ensure that one is better informed as a consumer.
Purpose of Life Insurance
In considering the acquisition of life insurance one has to be clear on its purpose. The purpose is to indemnify—it’s not an investment. One purchases life insurance to provide protection for one’s children or other dependents. The purpose is to protect the weak or dependent against misfortune by distributing the burden of the loss of one among many. As one is protecting for loss, then on that basis, there can be no money made and nothing created through life insurance.
Although the calculations in Life Insurance, undertaken by actuaries, are intricate these are founded on the basic principles of the law of average. All human events, such as births, deaths and casualties are found to occur with a certain average based on a large number of observations and over a long period of time. Thus, if we take a large number of people of the same age it is uncertain which one of them will die in any one year but it’s absolutely certain as to how many will die on average over the years until they are all gone.
The problem in life insurance has always been this: having a large body of people at a given age what annual premium must be charged to ensure that all the death losses in aggregate for many years can be paid out. The solution is dependent on three separate elements of cost of the insurance; the outgoings or claims paid out for the yearly deaths, the interest earned and the expenses of management. Averages are used with the younger people paying too much and the older too little. This is on the grounds that the older will have been paying longer for the cost of their risk contributing to the build-up of reserves for use in later years when the premium is unable to cover the cost.
Today however, the death feature of a policy or financial plan is only mentioned incidentally along with the words ‘investment’, total and permanent disability and trauma insurance features that are promoted as they are more salable and appealing. These variations rely on the theme ‘that it is to invest rather than insure’ and the insured may thus reap a reward from ‘Life Insurance’ during his lifetime as it is more likely that one of these risks will arise during one’s lifetime. In this way what was a principled enterprise has been degraded into a scheme that entices one to enrich themselves, and along the way allow agents and management to enrich themselves over the beneficiaries.
The conclusion is not to shun life insurance but keep its purpose in mind—being to provide protection for one’s children or other dependents.
- make a realistic assessment of insurance needs and,
- while circumstances of age and health permit, consider buying appropriate cover.
What insurance needs are appropriate? Here there are two important questions to ask; what financial needs will your survivors have after your death and what financial resources will be available to them.
Whether to have a corporate or individual trustee structure is a matter of choice. Arguments in favor of having a corporate trustee are that the assets of the fund are clearly separated from the individual trustees as they are registered in the name of the corporate trustee. There is also an ease with which members can change without having to change the registered details of each asset held by the fund.
The structure of a SMSF must meet certain requirements in terms of the law:
- it must have four or fewer members,
- each member must be a trustee / or director of the corporate trustee company
- no member may be the employer of another (unless related)
- no trustees are paid for their service
In the writers circumstances the corporate trustee option with the benefits outlined above, was was chosen, although more costly at the outset (approximately $620) and an ongoing, relatively low annual ASIC fee (approximately $50) for the company trustee.
Benefits from having a corporate trustee
The ATO provides information regarding these requirements, the costs, ownership of assets and succession benefits from having a corporate trustee.
Decision to set up a SMSF
The decision to establish a Self Managed Superannuation Fund (SMSF) is not easy. This decision requires considerable aforethought but any delay in setting up SMSF allows money in superannuation to build up to a level where the maintenance and set up SMSF costs are effective and sustainable. As a result there is no need to rush your decision. The second consideration is to be mindful to ensure that the “Self” in SMSF is attainable as, without members attending to the administration themselves, the costs would probably be prohibitive. Were one to require professional advisers to establish and maintain the fund then a SMSF may not be appropriate as it may not remain const effective. As a result there had been considerable planning and thought about these matters ahead of time.
Costs of Setting up SMSF
As my funds within superannuation amounted to just over $250,000, then on an annual basis, the administration costs were amounting to at least $5,900 per annum. What were the the steps in establishing the fund and what were the costs and process.
The ease with which one is able to establish the fund is remarkable. Online there are many service providers but cleardocs.com was chosen for a suite of Superannuation (SMSF) documents. Their website included an interface to ASIC to register a corporate trustee as this option was chosen in our circumstances. This choice of a corporate trustee is the subject of a separate post. The cost for the founding legal documents of the Superannuation Trust and Company structure was $397 with a further $469 for ASIC’s fee for the registration of the corporate trustee.
Steps setting up SMSF
The cleardocs website calls for:
- the names of the members of the fund,
- the trustee company name, addresses, and
once provided the Superannuation Trust Documentation Package, consisting of all legal documents and pre-prepared correspondence is provided. With the clear guidance online, the detail is easily completed and within minutes the documentation for structure is provided with confirmation of registration of the trustee company instantaneous.
In addition, a Superannuation Fund Establishment Kit is provided. This is very useful and clearly written, setting out all the steps for the proper completion and signing of the documents, and detailing other obligations.
Having received notification of establishment of the corporate trustee then once the trust documents were signed our SMSF was established. As a result of electronic messaging between ASIC and the Australian Tax Office the fund was also registered with the ATO. This process was simple, very comprehensive and easy navigate and was cost effective.
Risk of Living too Long negated through life annuity
Ensuring retirement income stream over remainder of one’s life is the key purpose of the superannuation system. The benefits of taking out a life annuity are explained but, for the reasons given below, it is quite rational, that people in Australia decide not to purchase an income stream in the form of an annuity.
The provision of the Australian Government Age Pension provides the ultimate protection against longevity. This leads one to avoid the more costly approach, the purchase of a life annuity, to cover one’s risk of living too long and thus running out of retirement income. A generally conservative investment strategy and margins deducted from returns detract from the efficiency of life annuities by reducing returns.
Conservative investment strategy
To provide a long-term income stream for life, requires the issuer of a life annuity to invest in assets that are highly likely to be around in many years’ time. These assets are therefore required to be secure and accordingly have a commensurately lower rate of return.
Margins to cover capital charges
The issuer of a life annuity is required to hold capital, to offer the protection against risks, insolvency and liquidity, and the providers of such capital require a return on their capital. Margins are therefore taken out of the asset returns, to compensate the providers of capital, reducing the return available to the life annuity holder.
Margins to cater for improvements in life expectancy
The uncertainty of improvements in the life expectancy of the general population is a risk that is borne by the issuer of life annuities. An additional margin therefore has to be allowed out of the returns on all assets to allow for this possibility.
The lower returns from the conservatively invested assets and the margins deducted from such returns results in lower income streams while the risk of the annuity provider failing remains with the owner of the annuity.
In early retirement, while well-being allows for a full lifestyle, the life annuity holder will under spend, and not have access to capital. Conversely, in very old age when lifestyle needs are far lower the annuity income remains and access to the Age Pension is also available. Thus the life annuity has come at a very real cost to the holder by having invested conservatively, carried all the margins to compensate the life annuities issuer for the risks. The net result of funding retirement income through the use of a life annuity results an under spending in the early years of retirement and then when lifestyle needs reduce significantly, at very old age, a level of income remains that cannot used, other than to leave by way of bequest, which is not the purpose of superannuation.
Superannuation is made up of:
- the accumulated contributions made into the fund over a person’s working life, and probably
- the value of life insurance in the event of premature death
The question you need to ask yourself is:
- How can I make sure that my superannuation balance will be enough for me to live on for the rest of my life?
- How do I work out how much insurance I need?
These questions are of vital importance to everyone. Very few people consider them and solve them satisfactorily.
If you are an employee, your superannuation contributions and therefore the ultimate accumulated balance is determined by how much you have earned over your lifetime. This does not reflect what you need for your retirement. Furthermore, in Australia the conversion of the accumulated superannuation lump sum into an income stream is not mandatory.
When it comes to the life insurance component, most people have no idea how much insurance is necessary to support their dependents. As the superannuation industry generally provides everyone with a nominal amount of cover without any careful and original thought to determine an appropriate level of insurance many are left with the false comfort that their insurance needs have been properly considered.
forethawte.com.au aims to offer some ideas for you to consider the superannuation lump sum required and a life insurance amount appropriate for you.
In planning your financial future the risks that you have, particularly with the potential for long-life, is that you superannuation balance will not support your desired income for your remaining life.
Secure income streams that guarantee the fulfillment of the planner’s desire for the provision of living expenses and ongoing support for the family are also not without risk.
An income from superannuation lump sum
The following simple story aims to explain the difference between a superannuation lump sum payout or a lump sum payout from life insurance policy and a regular income.
Suppose you went to a building contractor and said, “I want you to build me a house.” “What kind of a house?” “Well,” you say, “a Colonial, brick house, with ten rooms, three baths, and a sun porch, slate roof, hardwood trim and floors, open plumbing, and hot-water heat.”
Sometime later he calls you on the telephone and says, “I’ll drive you out to look at your new house.” You motor out to a beautiful section of the city and stop in the midst of a group of handsome homes.
The contractor says: “Here’s your house, just what you ordered.” But you are puzzled. There isn’t any house opposite the place where you have parked the car. “Where is my house?” you ask. “Right here,” he answers, pointing at the block before which you have stopped. “But there isn’t any house there,” you exclaim, in amazement. “There is nothing on that lot but a heap of bricks, barrels of lime, lumber, kegs of nails, building hardware, slate shingles, plumbing supplies, and cans of paint.”
“Well, I call that a house,” says the builder. “A house!” you exclaim. “Why, that is only the material out of which a house may be built.” A superannuation lump sum is only the brick and mortar of the House of Protection. And yet every day, all up and down this country, superannuation and related life-insurance policies, intended to furnish permanent support are settled in lump sum and people are saying to themselves with satisfaction, ”I have provided my family protection in event of my premature death.”
Adapted from: Lovelace, Griffin M., 1876-. The house of protection, 1921. New York and London, Harper & brothers.
Conversion of superannuation lump sum
The conversion of accumulated superannuation into an income stream is not mandatory. However the benefits of converting superannuation or a life insurance settlement into an income stream are enormous.
Most people believe that their superannuation or life insurance will provide for them into retirement or their dependents in the event of their premature death. The accumulated balance in superannuation represents a portion of a person’s average lifetime earnings and most people don’t plan how much this will amount to. Alternatively, how life insurance will support their dependents. Superannuation contributions are made at a mandated level and some people may have a basic level of life insurance. In order for these two things to provide for retirement or dependents, it’s important that they are invested to provide an income stream.
In these circumstances, dependents need to be protected. But how are they protected and indeed what is ”protection”? According to the dictionary, protection is that ‘which preserves or keeps from injury or harm’. What is the danger or harm from which superannuation and life insurance is intended to shield dependents? It is the lack of food, shelter, clothing, medical care, education, and reasonable comforts, either for life or for a specified period.
Does superannuation and life insurance, as it is arranged in the average case, really protect the beneficiaries against the lack of the necessaries and reasonable comforts of life? Unfortunately, there is no doubt as to the answer to this question. It is emphatically ”no.” The average person is not actually guaranteeing protection to the family, as thought.
The key feature of a life annuity contract is that it is payable for a person’s lifetime. The basic requirements of a life annuity contract are set out in the description and purpose of an annuity that is payable for the lifetime of the owner. Below is an explanation of the parties to an annuity contract as well as the various options available to you to allow you to tailor your annuity contract.
Parties to an annuity contract
A life annuity contract is created when you pay a lump sum to a life annuity contract issuer and agree on the terms of payments to be returned to you at regular intervals over your lifetime. The issuer of life annuities is usually a Life Insurance Company. The purchaser of an annuity is the person who wishes to receive the regular payment. The person who receives the regular payments of an annuity is referred to as the annuitant. The annuitant might be two people in which case they are referred to as joint annuitants. There are occasions where the purchaser of an annuity and the annuitant are different persons.
There are two different kinds of annuities:
- Guaranteed annunities
- Equity linked annuities
Guaranteed annuities explained
Guaranteed annuities are the traditional annuities and the older of the two under which the promised benefits are 100 per cent guaranteed by the issuer. Under a guaranteed life annuity, the level of income promised to the annuitant is based on the long term prevailing market interest rate at the time the annuity is purchased. Under this kind of annuity, the regular annuity is payable for the lifetime of the annuitant or another person.
Equity linked annuities explained
An equity linked annuity offers no guarantee of what you will earn from your annuity because the underlying investments from which the annuity is paid by the insurer is invested in equities or unit trusts and the return on these is uncertain. Equity linked annuities offer no certainty of income or the term over which the regular payments are receivable. The annuitant carries the risk.
Options available for guaranteed annuities
The initial payment for the annuity determines how much will be paid out as an income stream. The age of the person receiving and the annuity and their life expectancy determines the level of income they will receive. An older person will receive a higher income because of a lower life expectancy.
With reference to guaranteed annuities, the individuals can decide which of the following is important to them.
- the period over which the annuity is payable
- frequency of the income payments, and
- whether the payments escalate or reduce.
An annuity can be payable for a person’s lifetime or may be limited to a certain period. If it’s limited to a certain period, the income stream will generally be higher.
When you purchase an annuity, you can choose to have regular payments made annually, bi-annually, quarterly or monthly. Annuities are generally paid in arrears and less frequent income payments will result in slightly better income levels.
At the start, you can choose whether the life annuity is to change in line with changes in the consumer price index. Furthermore, if you have chosen a joint annuitant, you may elect a reduced annuity to be paid to the surviving joint annuitant on your death. By electing a reduced income for the second annuitant, you will benefit from a higher income stream initially.
Insurance against longevity
Longevity, is one of the imponderables to consider, when one reaches retirement. This question is how long will you live? Real problems arise when having contributed into superannuation and now a superannuation lump sum is available to you but, it has to last an indeterminate lifetime. One option available is to apply the lump sum to purchase a guaranteed life annuity.
A guaranteed life annuity pays out every year until, the annuitant specified under the contract, dies. A life annuity is therefore a compelling product as it “insures” you against longevity—living a long time, and thus risking running out of retirement income streams, while you are enjoying a long life. A guaranteed life annuity thus reduces the financial risk that comes with living into old age.
Risk of living too long
An annuitant living too long, beyond normal life expectancy, will accordingly gain from having taken out a life annuity. You will have protected yourself against the adverse financial consequences of longevity. Guaranteed life annuities are therefore very attractive to the healthy, as an income stream is guaranteed for the whole of one’s lifetime. Life expectancies for Australians are among the longest in the world and forecast to increase further but generally, people do not appreciate what their life expectancy is. This eliminates some of the financial implications of longevity, but the unhealthy could expect to lose out from buying a life annuity.
The result is that in entering into a life annuity contract there is a fear that the issuer of the annuity will fail, alternatively that the annuitant will die, very soon after taking the contract, the result being a windfall for the insurance company. In any event, the annuitant will lose the outstanding balance of one’s capital at death. Thus taking a life annuity is generally seen as a gamble.
Safety of annuities
However, issuers of annuities are life insurance companies, that are well regulated by the Australian and Prudential and Regulatory Authority, and are required to hold their assets in segregated funds. Furthermore, Life Insurance companies make adjustments to the contracted level of income through margins to run their operations, cover the risk associated with the assets backing the life annuities and to cater for an adverse selection against them were their life annuity products are taken by those who are more healthy than the general population.
Risk of dying young
An option available to purchasers to address the risks they perceive is to take joint and survivor guaranteed annuities. This annuity is issued with reference to the life of the annuitant and a dependant of the annuitant, usually the spouse. The annuity is guaranteed to be payable during the life of both the annuitant and continue for the lifetime of the joint annuitant.
Joint and survivor annuities may be structured to pay a constant amount throughout the lives of the two persons, or alternatively there may be a reduction in the annuity income level after the death of the first dying. This results in higher income levels to be paid initially.
Protecting capital in annuity
Although the focus of life annuities is to address longevity risk you may unnecessarily forfeit your capital if you die prematurely. To overcome the aversion to possibly losing capital, in the event of premature death, life annuity issuers have been offering a withdrawal guarantee for a substantial portion of the capital for and initial time of up to 15 years.
Does downside protection have its downside?