By Zoe Paterson

Clients who have worked hard to build wealth through their businesses and investments look to their accountants and advisers on how to secure their financial positions. Accumulating assets is part of the picture, but so too is protecting their families’ wealth.

Life insurance is a useful tool for guarding a family’s assets from being eroded due to unexpected injury, illness or death. For clients who have a self-managed superannuation fund (SMSF), it is a regulatory requirement to consider insurance arrangements as part of the annual investment strategy review, says A&T Financial Advisers director Tim Vander Kraats CA.

Licensed advisers who recommend their clients establish a new SMSF must first examine the client’s insurance needs. This includes discussing what type and level of cover they need, and any health issues that may affect their ability to access insurance.

“It’s going back to basics: What level of debt do they have? How old are their kids?” says Vander Kraats, an accredited CA SMSF Specialist.

Superannuation funds can hold term life insurance, which pays out on a member’s death; total and permanent disablement (TPD) insurance, which pays out if serious illness or injury prevents the person from ever returning to work; and income protection or salary continuance cover, which replaces some of the person’s earnings if they are temporarily unable to work.

A 2018 Australian Securities and Investment Commission (ASIC) report, Report 575 – SMSFs: Improving the quality of advice and member experiences, found 19% of SMSF members did not consider insurance when setting up their fund. (And 30% of SMSF members had no arrangements in place for their SMSF if something happened to them.)

If the SMSF’s insurance arrangements change, the fund’s investment strategy must also be reviewed says CA ANZ superannuation leader Tony Negline. This is another requirement that is frequently overlooked, and trustees who fail to comply can be personally fined around A$10,000 each. So accountants need to be on the front foot.

Picture: Tony Negline.

Look for value in existing insurance policies

“A trustee should consider their investment strategy – annually, it might be that they make no changes but at the very least they need to turn their attention to it,” says Negline. “And if the investment strategy changes then insurance will need to be reviewed, likewise if insurance needs within a fund change the investment strategy will need to be reviewed.”

For some SMSF members, it may be useful to also retain an account in a retail or industry superannuation fund to access group insurance policies.

SMSF members who hold insurance through a public offer fund now have to monitor their account more actively, under Protecting Your Super rules in effect since 1 July 2019.

With the Protecting Your Super changes, if the account is inactive for 16 months, the member needs to make a contribution or elect to opt in to retain that insurance.

Clients who fail to contribute or opt in will have their insurance policy cancelled and it may be difficult to have it reinstated.

One-third of SMSFs that hold money in another superannuation fund do so to obtain cheaper insurance, according to Investment Trends’ SMSF Investor Report from March 2017, which was referenced in ASIC Report 575.

Walker Wayland director Iggy Moro FCA, who is an accredited CA SMSF specialist, has several SMSF clients who have taken this approach.

“We’ve certainly had clients who have had public offer funds for long periods of time and, because of the age that they started paying those premiums in super, there wouldn’t have been any exclusions or loadings,” he says.

Picture: Iggy Moro FCA.

“On establishing an SMSF in their 40s, the premiums and the loadings might be higher… particularly if they’ve had some health event, it may be better to maintain that public offer fund.”

Beware of the fine print and insurance policy definitions

Whether they’re planning to continue with an existing insurance policy, or buy a new life insurance product, SMSF trustees need to understand the fine print, says Hall and Wilcox partner Heather Gray – a specialist superannuation lawyer.

Picture: Wilcox partner Heather Gray.

Understanding the different types of TPD cover is one example where trustees can benefit from expert advice, she says.

In the past (prior to 1 July 2014), TPD policies within super funds regulated by the Australian Prudential Regulation Authority typically paid a member’s claim in the case of a disability that meant the member lost the capacity to work in their ‘own occupation’.

Legacy products remain in the market but people who claim against them may have trouble accessing the payment, Gray says. “The insurance policy might pay up but the claims process may be trapped in the superannuation fund because you wouldn’t have met an appropriate condition of release.”

Today, it is more common for TPD policies to apply a ‘similar occupation’ test, meaning claimants are only eligible for a payout if, following retraining, they’d be incapable of returning to work in a similar job. Some TPD policies, however, require claimants to meet the even more extreme definition of not being able to work in ‘any occupation’.

“If you were a specialist surgeon, for example, and you suffered a cognitive disability but you were able to work as a sales assistant, then you wouldn’t be covered by TPD insurance [with an ‘any occupation’ clause] because there is an occupation that you are able to do,” Gray says.

CA ANZ’s Negline notes that SMSF advisers have an important role to play in helping clients navigate these complexities.

“The job for a super fund trustee is to marry up the super laws, their trust deed and the terms of an insurance contract so that they are all operating properly together,” he says.

The variations in terms, conditions and exclusions make it difficult to compare policies, says Saward Dawson director wealth advisory Vicki Adams CA – a CA SMSF specialist.

“You might find that a policy is quite cheap but it may be more difficult to claim on,” Adams says.

“You might find that a policy is quite cheap but it may be more difficult to claim on.”

One policy may pay out on the condition that the person is ‘incapable’ and ‘unable’ to ever return to any occupation, while another may use the term ‘unlikely’.

“ ‘Incapable’ or ‘unable’ is a higher threshold to prove than ‘unlikely’,” Adams points out.

Some policies include clauses that require claimants to retrain, allowing a greater range of occupations to be considered before a claim will be paid out.

Picture: Vicki Adams CA.

Holding insurance outside vs inside super

Holding insurance policies outside the superannuation environment altogether is another option, although the benefit of this may only eventuate if a policy pays out.

Premiums for policies held inside superannuation are paid out of money in the fund, rather than the member’s own pocket, which offers cash-flow benefits.

The cost of policies held inside superannuation is tax deductible, while premiums for term life and TPD cover held outside of superannuation are not. (Although individuals can claim a tax deduction for premiums on income protection policies held in their own name.)

“That means you can effectively take out a higher level of insurance for the same post-tax cost,” explains Gray.

However, what’s often overlooked are the tax consequences for independent beneficiaries of holding insurance through super. If insurance is held outside of superannuation, claim proceeds are tax-free, regardless of who receives them. But payouts from policies held within super are only tax-free to people who are dependants of the deceased, including a spouse and minor children, Gray explains.

“If an insurance benefit is paid to an independent adult child from within a superannuation fund which has claimed deductions for the premiums, [the payout] is taxed at 30% as it’s considered to be an untaxed element of the fund,” she says.

“If there’s a possibility that the insurance proceeds will end up in the hands of an independent adult child you need to gross up the amount of insurance you take out to take into account that 30% of it is going to be lost to tax.”

When life insurance proceeds are paid directly by the super fund trustee to a non-dependant, the taxable component of the payment is added to the individual’s taxable income, says Vander Kraats.

“That will potentially affect the childcare benefit, the Medicare levy, and the Medicare levy surcharge. Anyone earning over A$250,000 has to pay an extra15% tax on super contributions – and getting over A$250,000 in one year is probably easy when you’re receiving an insurance payout,” he says. “Paying those additional taxes – even just the Medicare levy at 2% –can add up when you’re talking big numbers.”

An alternative is to have insurance benefits paid into the deceased member’s estate before being distributed to adult children via a binding death benefit nomination or via the will. In this case, the estate pays the tax before passing the payment to the beneficiary.

“There’s no [additional] tax to pay and the recipient doesn’t have to declare it in their income tax so there’s no impact on the childcare benefit or the Medicare levy surcharge, which can add up to a significant difference,” Vander Kraats says.

Although there may be a higher risk that the payment could be contested if it’s paid through the will and estate as opposed to directly to the dependants, Vander Kraats says, “That has to be a consideration.”

Lifetime costs of a life insurance policy

Long-term affordability is a key issue for SMSF owners when considering life insurance. One factor that affects the cost is whether premiums are level or stepped.

Level premiums remain constant, rising only in line with inflation. Stepped premiums are initially lower – in most cases less than half the cost of level premiums – but increase over time.

Which premium type is most cost effective over the policy’s lifespan will vary depending on factors such as the client’s age, health and level of coverage, says Vander Kraats.

Playing into this equation will be the SMSF member’s future expectations and requirements for flexibility.

Level premiums may be more cost-effective for policies that will be maintained for the long term, but if the level of cover will be reduced over time, stepped premiums may work out to be cheaper overall.

Advisers can analyse whether stepped or level insurance premiums are more cost effective by looking at the break-even points.

Vander Kraats, now in his early 30s, examined the cost for his own situation of A$1 million of term life and any occupation TPD coverage held through superannuation. The stepped annual premium for the policy he considered was A$831 initially, and remained close to that amount for six years, before rising steadily. The level premium was fixed at A$1839.

“The year in which level premiums become more affordable than stepped for myself personally is 15 years,” he says. “For cumulative premiums, where they cross over is 23 years.”

Vander Kraats expects that in 15 years he will have paid off debt and accumulated enough assets to warrant reducing his level of coverage. Over that timeframe, he would have paid a total of A$29,424 if he selected level premiums, while the cumulative cost of stepped premiums would have been only A$16,996.

“You have to have quite a long-term horizon if you’re going to choose level premiums,” he says.

Beware the A$1.6 million cap on super funds

Dependent beneficiaries do not pay tax on an insurance payout from a policy held within a super fund, and they can take the benefit either as a lump sum or an income stream.

When planning what to do with payouts, SMSF owners need to be aware of the A$1.6 million transfer balance cap. The transfer balance cap limits the amount that a member can move into a tax-free pension account in their superannuation fund to A$1.6 million.

“If the insured benefit is higher than A$1.6 million then the beneficiary can take up to A$1.6 million worth as a pension or income stream and they must take the remainder as a lump sum. It has to be cashed out of the fund,” says Gray.

“If the insured benefit is higher than A$1.6 million then the beneficiary can take up to A$1.6 million as a pension or income stream and they must take the remainder as a lump sum.”

The exception to this rule is where insurance proceeds are paid as a reversionary pension to the dependent beneficiary. In this case, the beneficiary has 12 months before the pension’s value is allocated to the A$1.6million transfer balance cap, she says.

This delay buys the beneficiary time to make decisions, says Vander Kraats.

“The surviving spouse would have up to 12 months to decide what to do with the balance, which may not sound like a lot of time but if there’s a large property or shares, they get 12 months to decide whether to sell it or hold onto it,” he says.

The A$1.6 million cap may also affect some trustees when paying insurance premiums from a super fund.

One of the drawbacks to holding insurance through super is that premiums reduce the fund’s balance unless the member makes contributions to offset their costs.

Clients who have already made concessional contributions (such as employer super guarantee payments and salary sacrifice amounts) up to the annual A$25,000 limit can make further concessional contributions, however these are subject to tax at marginal rates.

Individuals with a balance of A$1.6million or more cannot accept further non-concessional contributions (personal contributions made from after-tax money). There are also restrictions on non-concessional contributions for those with balances between A$1.4million and under A$1.6million.

Moro suggests that if other members of the super fund have not yet reached these caps, they could contribute enough to cover the premiums so the fund does not have to sell assets to pay for the premiums.

“For example, if you have a member who’s nearing the A$1.6 million cap and they have insurance premiums, you reduce their member balance by that insurance premium, and if there’s a second member of the fund who is contributing cash into the fund, their cash can pay for that premium because the life insurance gets paid by the fund,” he says.

In doing this, it’s important to allocate the premium to the member who is being covered by the insurance, and allocate the contribution to the member who added money into the fund.

Schedule regular life cycle reviews for insurance

Approaching the A$1.6million limit should act as a reminder to SMSF trustees to comprehensively review their insurance arrangements, says Moro.

Other major life events – such as the birth of a new child or grandchild, divorce, or the death of a beneficiary – may also trigger the need for a review, he says.

Moro recommends clients conduct a more comprehensive review of their arrangements every two to three years.

“As people age there needs to be are view of where and how life insurance is paid,” he says. SMSF members need to weigh up the tax and cash-flow benefits of having their policy in a super fund, against the tax consequences for their beneficiaries who will receive a death benefit payment, particularly for non-dependants.

“As people age there needs to be a review of where and how life insurance is paid.”

Chartered accountants can help their SMSF clients understand their wealth protection needs and, where necessary, refer them to insurance specialists for further advice. Doing this improves their clients’ financial security, whatever the future may bring.

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