Understanding Income Protection and the Importance of the Deferred Period
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only. You should always seek professional advice from an appropriately qualified adviser.
All contents are based on our understanding of current legislation, which is subject to change, any information provided here is only correct at the time of posting.
When it comes to financial planning, an important aspect to consider is how to protect your income in the event that you are unable to work due to illness or injury. This is where income protection comes into play. Designed to provide you with a safety net, income protection can help to ensure that you can maintain your lifestyle and meet your financial obligations even when you cannot earn your regular income. But when setting up an income protection policy, one crucial factor that must be considered is the deferred period.
What is Income Protection?
As quick recap, Income protection insurance is a type of insurance policy that provides you with a regular income if you’re unable to work due to illness or injury. Unlike other types of insurance, such as critical illness or life insurance, income protection is designed to pay out on a long-term basis, potentially until you reach retirement age. Although, it should be noted that there are short term products available too, which will only pay for one or two years for each claim. The payout from an income protection policy is usually a percentage of your pre-tax salary, often around 50-70%, and it continues until you are either able to return to work, your policy ends, the claim period ends, or you retire.
Income protection policies are particularly important for those who do not have significant savings or other forms of financial support in the event of long-term sickness. While many employers offer some form of sick pay, this often only covers the short term. An income protection policy can provide peace of mind by ensuring that you have a steady income stream if you are unable to work for an extended period.
It is important to note that upon claim, an insurer may take into account any other income (i.e. employer sick pay) which will reduce the payment if you choose the incorrect deferred period.
What is the Deferred Period?
The deferred period is the length of time between when you first become unable to work and when your income protection payments start. It’s also known as the waiting period. The deferred period can range from a few weeks to several months, with common options being 4 weeks, 8 weeks, 13 weeks, 26 weeks or even a year.
During the deferred period, you will not receive any payments from your income protection policy. Therefore, it’s crucial to choose a deferred period that aligns with your financial situation and existing benefits, such as sick pay from your employer. The longer the deferred period, the lower your monthly premiums will be, as there is a lower likelihood of a payout being needed. Conversely, a shorter deferred period will result in higher premiums but ensures that you receive income sooner.
How to Calculate the Right Deferred Period for You
Choosing the right deferred period is a balancing act between your financial resilience, your employer's sick pay provisions (if applicable), and the affordability of your premiums.
1. Assess Your Sick Pay: If your employer offers generous sick pay, you might be able to opt for a longer deferred period. For example, if your employer provides 6 months of full pay in the event of illness, a 26-week deferred period might be appropriate, as your income protection would start paying out just as your sick pay ends. If you are self-employed, you may not have any sick pay arrangements in place at all making this type of protection even more vital.
2. Consider Your Savings: If you have substantial savings, you might choose a longer deferred period, as you could live off your savings for a few months before needing to rely on income protection payments. Conversely, if your savings are limited, a shorter deferred period may be more appropriate to ensure that you have a continuous income stream.
3. Evaluate Premium Costs: A shorter deferred period will result in higher premiums. It’s important to strike a balance between the cost of the policy and the level of protection it provides. If you’re on a tight budget, extending the deferred period could help reduce your monthly premium costs, though it may mean you have to rely on other sources of income or savings during the initial period of your illness.
4. Consider the Nature of Your Work: If you work in a high-risk profession where illness or injury is more likely, you might prefer a shorter deferred period to ensure quicker access to your income protection payments.
Advantages and Disadvantages of a Shorter Deferred Period
Advantages:
Faster Access to Benefits: A shorter deferred period means you receive your income protection payments sooner, which can be crucial if you have little in the way of savings or sick pay to fall back on.
Increased Peace of Mind: Knowing that you won’t have to wait long to receive benefits can provide significant reassurance, especially if you’re the primary earner in your household.
Disadvantages:
Higher Premiums: The most significant downside to a shorter deferred period is the higher monthly premiums. This could make the policy less affordable in the long term.
Real-Life Example: Income Protection with a 3-Month Deferred Period
Let’s consider an example to illustrate how income protection with a 3-month deferred period works.
Sarah, a 35-year-old marketing manager, decides to take out an income protection policy. She earns £50,000 per year and wants coverage until her retirement age of 65. After reviewing her employer's sick pay policy, she finds that she would receive 3 months of full pay if she were unable to work due to illness or injury. Based on this, Sarah chooses a deferred period of 3 months (13 weeks).
At age 40, Sarah unfortunately develops a chronic condition that prevents her from working. After using up her 3 months of sick pay, her income protection policy kicks in. The policy pays out 60% of her pre-tax income, amounting to £30,000 annually. This payout continues until she reaches the retirement age of 65.
Outcome: Over the 25 years between age 40 and 65, Sarah receives £750,000 in total from her income protection policy. This regular income allows her to maintain her lifestyle, pay her mortgage, and meet other financial obligations despite being unable to work.
Conclusion
Choosing the right deferred period is a critical decision when setting up an income protection policy. It involves weighing the cost of premiums against the financial risk of waiting too long for your payments to start. Where applicable, by carefully considering your employer’s sick pay, your savings, and your financial responsibilities, you can select a deferred period that provides you with the optimal balance of affordability and protection. As discussed, if you are self-employed, this type of cover should be even greater consideration as you may not have the option of sick-pay available meaning you deferred period may need to be shorter.
As always, you should speak to a suitably qualified financial adviser who will be able to recommend the most suitable policy and deferred period for your personal financial circumstances.