Inflation may well be lower than ever before in 2015 but history suggests that this is unlikely to stay this way in the medium to long term and when you take out a policy that may pay-out for 40 years it is sensible to consider the impact of inflation on your chosen benefit amount.
The level of income that covers your outgoings now is extremely unlikely to be adequate by the end of the policy term or even in 10 years’ time, if previous experience is any guide. For £100 in 1990, you would need £214 in today’s money to have equivalent buying power, or to look at it another way your £100 25 years ago and be worth £47 in today’s money.
To ensure your income protection policy still protection properly against loss of income, you may wish to link your benefit amount to inflation, whereby the amount of cover increases annually to match the retail price index (RPI) typically. However, be aware that this does not guarantee your policy will always cover your outgoings, as they could increase faster than RPI, so your cover amount should be regularly reviewed with your adviser.
When the cover amount is increased annually through policy indexation, the premiums will also increase to reflect the extra cover, however, the premium increase is calculated in very different ways depending on which insurance company your policy is with. The different methods used are shown below and are based on a hypothetical inflation rate of 2%:
- 1:1 – a premium increase matches the cover increase i.e. cover up 2% = 2% premium increase.
- 1: 1.4/1.5 – premium increases by 1.4/1.5 times the cover increase i.e. cover up 2% = 2.8/3.0% premium increase.
- 1: 1 + 2.5% - a premium increases by 2.5% more than the cover increase i.e. cover up 2% = 4.5% premium increase
- Age banded – the increased cover cost is calculated at the policyholder’s age when the increase is applied, becoming much more expensive as age increases, where a cover rise of 2% can lead to a premium increase of 8% or more.
This type of information is incredibly difficult to find on insurance company websites, which is just one reason why it is so important to speak to an income protection expert before taking out this type of policy.
The raw figures shown above do not easily show what a massive impact these differing indexation methods can have on your income protection premiums over time. The graph below illustrates this impact much more clearly.
Based on a £30 starting premium with cover increasing at 3.0% by the different insurer methods