People are often confused about what to do with the life insurance benefits they are entitled to receive after the policyholder’s demise – invest it to generate regular income, use a part of the lump sum each month until it lasts, or find another way to channelize the proceeds productively.
In fact, a nationwide study by Forbes LearnVest on Life Insurance revealed that 66% people do not fully understand their life insurance policies. This brings us to an important point – simply leaving behind a substantial amount as death benefit is not sufficient, your dependents must also know how to put that lump sum to effective use, failing which, they may face financial problems.
Policyholders may feel that a suitable life insurance product with a large sum assured is sufficient for their dependent family to achieve important life goals and maintain their lifestyle. However, the fact remains that regular expenses need to be met on a monthly basis, and a one-time lump sum may sometimes leave the beneficiaries puzzled about how to invest/use it, especially if they are not familiar with the financial mumbo-jumbo.
Income Replacement Life Insurance Products
Bearing this in mind, a large number of global life insurance companies have launched a new product variant of life insurance – an income replacement life insurance product. These products come to rescue, if the policyholder feels that his/her family may not be able to efficiently handle/invest the lump sum payout.
Income replacement products, upon the insured’s demise, pay out part of the benefit as a lump sum, and also pay a regular monthly income over a period, say 10-15 years. In other words, income replacement products split the entire sum assured into a one-time payment, plus a continued monthly payment as well. But what makes these products really interesting is the fact that the total amount, beneficiaries/nominees receive, over a period, is more than the sum assured specified in the policy.
As an alternative, the lump sum amount could remain the same, and an additional amount will be paid to the policyholder’s family, every month. Here, although the annual premium would go up to a certain extent, it would be worth it because:
- The return on money invested would be high
- The nominee(s), at that point, may not be in a state of mind to figure out ways to maximize returns
Income replacement life insurance plans makes sense for single earning households, and where one’s spouse/family is not financially smart or comfortable making robust investment decisions.
Product variants
Income replacement life insurance products have three broad variants offering staggered payouts:
- Fixed monthly payout for certain number of years – For instance, INR 1 crore sum assured would be paid out over 100 months in monthly installments of INR 1 lakh
- Part of the sum assured is paid as lump sum and the remaining paid out on a monthly basis for a fixed number of months – For instance, INR 50 lakhs lump sum and INR 50,000 paid monthly for 100 months
- Monthly payouts that increase at a pre-specified rate annually for a certain number of years – at a fixed percentage or as per the rate of inflation
Benefits & Advantages:
Affordable: Income replacement insurance plans are not too expensive – the premium is similar to regular term insurance plans.
Comfort zone, sufficient time to plan: It may not be particularly easy, especially for those not financially well informed, to invest a large corpus in the right investment channel. Families are usually used to the idea of fitting in monthly expenses within a specific amount that the breadwinner earns, which becomes like a comfortable habit.
An income replacement life insurance product ensures that the policyholder’s family stays in this same comfort zone for at least the next one or two decades following the policyholder’s demise. This also gives sufficient time to the family to devise alternate income sources or figure out how to generate income from assets left behind by the policyholder.
Limitations
- As seen above, in income replacement insurance plans, the payout is staggered over several years. It may therefore be confusing to understand and compare these plans as easily as simple term insurance plans.
- One will have to discount cash flows from income replacement insurance plans while comparing two similar plans. Here, choosing a discount rate becomes a problem. However, an expected approximate inflation rate can be taken as the discount rate.
- Income replacement term insurance products could be structured in varied ways. Therefore, the buyer may end up getting confused and purchasing a product that he/she does not understand fully.
- Some income replacement term plans have fancy names that could confuse buyers.
Understanding What to Do
General
Always involve your family members – spouse, parents, and other dependent members in all your financial decisions. When you purchase a regular term life insurance product, they must be informed. If you opt for an income replacement life insurance product, they should know the reason why. This will help your family understand what they can expect and what exactly is expected of them when you are no longer around.
For those who are unfamiliar with the nitty-gritty of finance or do not understand financial investments in detail, it may be tough to understand financial concepts like CAGR or cost of financial products, etc. Hence, as a policyholder and family member both, it is important for you to financially educate your family, bearing in mind that they are laypersons. A part of this financial education is encouraging your family to read about finance in newspapers or online blogs, as this will help improve their understanding of finance and financial products.
Discuss with your spouse/family how you want the insurance policy proceeds to be used. This will help avert financial hardships in difficult times. It even makes sense to put down the plan in writing, so your family can refer to it if the unfortunate were to happen.
In terms of insurance plans
Begin by computing your life insurance needs. Then, compare insurance quotes and buy a regular term plan that covers all your needs. A lump sum amount may be required to settle certain big financial liabilities like a home loan, education loan, etc. Stick to a regular term insurance product if you are sure your dependent family can easily manage the insurance lump sum payout to churn out regular income.
Similarly, if you have substantial assets that can generate regular income for your family, you would only require a regular term plan and not a variant. For example, if you own a second home or office that generates sufficient rent to meet your family’s monthly expenses, then an income replacement term insurance product would not be needed.
Add an income replacement term insurance plan to your portfolio if you are sure that your dependent family will not be able to invest a lump sum in the right investment channel. Here, it is important to make sure that the monthly payout from this income replacement insurance plan is in line with your monthly take home salary or monthly expenses.
If confused, consider buying a term plan that offers both lump sum as well as income benefits.
If the premiums for two plans, i.e. the regular term insurance plan and the income replacement plan, weigh you down financially, consider reducing the life cover under the regular term plan. It is however advisable to be over-insured rather than under-insured.
Ideally, in addition to an income replacement term insurance product, it is good to have a regular term plan as well. This is because income replacement plans are not life annuity products – they do not provide monthly income for a lifetime, and the monthly payout stops after a specified number of years.
It is important that before the monthly payouts cease, the policyholder’s dependents – spouse/parents/family learn how to generate substantial income from the assets left behind or are able to figure out an alternate source of income.
Over to You!
Whether you need only an income replacement term insurance plan, only a regular term plan, or both, completely depends on your specific situation and financial requirements. An experienced financial planner or a certified investment advisor can assist you in structuring your insurance portfolio and working out the exact plan and numbers.