You have bought a term cover of Rs 1 crore. As per your calculation, the amount should be enough for your dependent family to maintain their lifestyle and achieve all important life goals (education, accommodation, healthcare, marriage etc). Let’s assume Rs 1 crore is enough.
If something were to happen to you, your family will get a lump sum amount of Rs 1 crore. However, the expenses of your family won’t be lump sum. They will need to some amount every month to meet monthly expenses. An aspect that worries me is how to use this lump sum amount to generate regular income.
I was talking about my term cover with my wife a few days back. Of course, she was reluctant to talk about this. But when I insisted, she relented. After listening to me patiently, she asked me a question, “What should I do with this money? How should I invest this money?” I realized leaving behind a good amount is not enough, the dependents must also know how to use that lump sum.
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Have you asked yourself the same question?
Can your family manage to generate regular income from this lump sum amount?
Certainly not easy for someone who has no prior experience of investing and selecting financial products based on requirements.
Moreover, once the money reaches your spouse’s bank account, tens of agents of financial products (primarily insurance companies) will start preying on that money. Most of them will be the least bit worried about financial and emotional stress your family must be going through. They will be more worried about their commissions.
Even distant relatives (with every bit of good intention) will start offering financial advice. Everybody is an expert advisor.
For someone who has never made investment decisions before, it is not easy to handle so much noise. That too in times of such emotional stress.
Is there a way by which your family can be spared this stress?
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Variants of Term plans
Term plan is the best form of life insurance. And it remains so. However, a term plan can also come in multiple variants.
Just like regular term plans, there will be no maturity benefits in any variant.
The nominee gets the Sum Assured only in the case of demise of the policy holder.
The difference is in the way the Sum Assured is paid to the nominee or beneficiary under the policy.
In regular term plans, the entire Sum Assured is paid to the nominee in the event of death of the policy holder.
Under other variants, this may not be the case. The payout may be staggered. Some examples are:
- Fixed monthly payout for a certain number of year (say 120 months) e.g. Rs 1 crore of Sum Assured will be paid as monthly installment of Rs 1 lac for 100 months.
- Part amount as lump sum and remaining as monthly payouts for a fixed number of months. Rs 50 lacs lump sum and Rs 50,000 per month for 100 months.
- Monthly payouts which increase at a certain rate (rate of inflation or a fixed percentage) every year for a fixed number of years.
There can be any number of variants. Insurance is a contract and a contract can be put down in any way.
Let’s call these variants of term plans Income Replacement Term Insurance Plans (to differentiate from regular term plans). There is no standard nomenclature. I researched a few plans but could not find a consistent name. Income Benefit Plan and Income Replacement Term plans were most commonly used.
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What are the benefits of Income Replacement Term Insurance Plans?
Generating income from a corpus is not the easiest job in the world. Additionally, our brains are not programmed in such manner. Your family has a monthly income and the family tries to adjust expenses within that income. Your spouse (family) has been doing this for many years. And it is difficult to get rid of these old habits.
An Income Replacement Term Plan will ensure that your family stays within that comfort zone for another 10-20 years. In the meantime, your family can develop an alternate source of income or learn to generate income from the assets you left behind.
The premium for income replacement plans is comparable to regular term plans. Hence, such plans are not expensive either.
We will see this through an illustration later in this post.
What are the problems with Income Replacement Term Insurance Plans?
Regular term plans are the easiest to understand. If the policy holder dies, the beneficiary gets the Sum Assured.
These plans may not be as easy to understand.
With Income Replacement Term Insurance plans, the payout is staggered over multiple years. Hence, it may not be as easy to understand these plans.
- Unlike regular term insurance plans, comparing these plans is not easy.
- You need to discount the cash flows from the Income Replacement Term Plan if you want to compare two such plans. The choice of a discount rate is a problem in itself. You can use expected inflation as the discount rate.
- Fancy names for such income replacement term plans can confuse you.
- Since the product can be structured in so many ways, the product itself may not be so easy to understand. Hence, you may end up purchasing a product that you don’t fully understand.
Illustration
HDFC Click 2 Protect Plus plan (from HDFC) is a term life insurance plan and comes in three variants.
- Life option: Lump Sum payout of death benefit
- Income Option: 10% of Sum Assured payable on death. Remaining 90% shall be paid be monthly income for as monthly income for the next 15 years (0.5% of Sum Assured every month)
- Income Plus Option: 100% of Sum Assured to be paid on death. Monthly income (0.5% of Sum Assured) paid for the next 10 years. The monthly income can be chosen as level or increasing at 10% p.a.
You can see first variant is a regular term plan while the remaining options are Income Replacement Term Insurance plans
Please understand income replacement term insurance plans can be structured in any way. So, you can have a plan where there is no lump sum payment at all and the entire Sum Assured is paid in monthly installments. 10% could be 35% or 50%. (under income option). This is something you need to watch out for.
Let’s compare the premium for the three variants for Sum Assured of Rs 1 crore for a 30 year old non-smoker male. Policy term is 30 years.
You can see, in the first two options (life and income), total payout is same. However, in the income option, most of the payout is staggered over 15 years. Hence, the present value is only ~Rs 62.3 lacs.
That is why annual premium for Life Option is greater than annual premium for Income Option.
The payout form the Insurance company is higher in Income Plus options. That’s why the premium for Income Plus option is also higher.
Please understand this plan from HDFC Life has been considered only for demonstration purposes and shall in no way be construed as my recommendation for the life insurance product.
PersonalFinancePlan Take
When you calculate life insurance requirement, the underlying assumption is that the beneficiary knows how to use the money. If your spouse (or family) has no idea about how to invest the lump sum amount, your family may face serious financial problems after a few years.
When it comes to life insurance, you must take decisions that are easy to understand and implement for your family. It is acceptable even if the choice is a bit sub-optimal.
If you think spouse (family) may find it difficult to handle the lump sum amount efficiently, you can consider Income Replacement Term Insurance Plans.
Income Replacement Term Insurance Plans make a lot of sense if yours is a single earning household and your spouse (family) is not financially savvy or comfortable with making investment decisions.
What should you do?
- Involve your spouse (family) in all the financial decisions. If you are opening an FD, tell them why you are opening a fixed deposit (and not purchasing a traditional insurance plan with tax benefits). Experience is the greatest teacher.
- For someone who has not taken courses in mathematics or finance or is not financially savvy, it may not be so easy to understand investment return concepts such as CAGR or the cost of a financial product. It is your duty to educate your family.
- Encourage them to read personal finance sections in daily newspapers or visit certain personal finance blogs regularly. Slowly but surely, their understanding of financial products will improve. I understand it is easier said than done. But, slow and steady wins the race.
- Discuss (or rather debate) with your spouse how you want insurance proceeds to be used. I know such subjects are never broached in our families but such discomfort is much better than the prospect of financial hardship for your family. You can even put the plan down in writing. Your family can refer to the same if the most unfortunate were to happen.
What you should do about your insurance needs?
- Calculate your life insurance requirement and purchase a regular term plan for the same. Lump sum amount may be necessary to square off certain liabilities e.g. home loan etc.
- If you are confident that your spouse (or family) will be able to manage the lump sum amount to generate regular income, then there is no need to purchase another insurance plan.
- Alternatively, if you have created assets which can provide regular income to your family, you only need a regular term plan (and not a variant). For instance, if you have a second home which provides rent good enough to meet family’s monthly expenses, you do not need income replacement term insurance plan.
- If you feel your spouse (family) is not financially savvy, you can add an income replacement term insurance plan to your portfolio. The monthly payout from the insurance plan shall be in line with your monthly take home salary (or at least monthly expenses).
- If the premium for the two plans is too much for you, you can reduce the life cover under regular term plan. However, I would rather be over-insured than under-insured.
- You can also purchase a term plan that provides both lump sum and income benefits.
To be honest, there is no crisp answer to whether you need an Income Replacement Term Insurance Plan. It depends on your specific situation. So, you are the best judge.
You can seek services of a SEBI Registered Investment Advisor or a fee-only financial planner to help structure your insurance portfolio. Such advisors will help you work out the exact numbers.
Regular term plan is necessary since the payout from Income Replacement Term Plans stops after a few years. Income Replacement term insurance plans are not life annuity products i.e. these plans do not provide monthly income for lifetime. The monthly payout will stop after a few years (10, 15, 20 or as the case may be). Before the monthly payouts stop, your spouse (family) must learn to generate income from the assets you left behind or create other alternate source of income. Awareness about financial products is an absolute must.
Image Credit: DLG Images, 2015. Modified. The original image and information about usage rights can be downloaded from Flickr/DirectLine