Whilst ‘Income Protection Insurance’ may sound simple, i.e. a policy that pays out when you can’t work due to illness or injury; it is remarkably complex in its offer. What you’ll receive in time of need all depends on certain option choices and the cover’s restrictions. For example; what you would like the claim term to be; whether you would like any additional benefits; or the amount of cover you need.
All of these differentiation factors require careful consideration when taking out Income Protection, primarily because they will affect the policy cost and the amount and duration of monthly pay-outs. One of the more complex questions that we get frequently asked is: does my income protection increase with inflation? When looking at the different types of income protection insurance, index linked income protection is one of the options available. This article aims to look specifically at this in a little more detail.
Should I get Indexed Linked Income Protection?
When you first take out income protection, you do so, on the basis of your current monthly earnings and outgoings. However, as the years go by, the cost of goods and services will tend to go up over time due to inflation. This means, of course that say, in five years’ time, your average monthly spend will likely to have risen from what it is today.
In answer to the question: does my income protection increase with inflation? This all depends on whether you’ve ‘Index Linked’ your policy, or your policy includes ‘Indexation’. Both these terms mean protecting your policy against inflation, therefore ensuring your Income Protection cover keeps pace with annual price rises.
Whether a short term or full term income protection policy the longer the policy duration the more likely your monthly benefit will depreciate over time in real terms. In the future, this means that the pay-out that could have easily covered some of your essential outgoings may not even cover your electricity for the month. Therefore, if you are planning on Income Protection cover, to make sure your claim benefit is just as valuable as it was when your policy started, it is far better to take Index Linked Income Protection.
A key consideration to this is you cannot exceed a certain percentage of your salary. If you are on the maximum available cover based on your salary then unless you income increases each year accepting the index linked increase would be inappropriate. This is because the policy would only be able to pay out the maximum the policy allows, up to 65% of your gross income, and you could end up paying for a policy you will not get the full benefit of.
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How does Index Linking work?
Also known as the inflation proofing option or cost of living, index linking Income Protection works by enabling your benefit entitlement and consequently your monthly premium to be linked to an official index from the Office of National Statistics. Depending on your policy, this index could be either: the Consumer Price Index (CPI), Average Weekly Earnings (AWE) or the Retail Price Index (RPI).
Your Income Protection cover and monthly premium is renewed annually in line with the chosen Index and if necessary increased to be in line. If changes to the Index are 1% or less then both the cover amount and the premium will typically stay the same until the next review. Over this percentage and either your premium, cover or both will increase. The premium can increase at a different rate to the cover amount because it’s typically indexed in line with the Index multiplied by two, although this does vary. This is because it will take into account the likelihood of you making a claim due to the increase in your age.
The insurer will write to you before the anniversary of the policy to give you the indication of increase for both premium and sum assured at which point you can either accept or decline the increase for that year. There will only be a limited amount of times you can decline the increase, typically concurrent years, and they will then not offer the option to increase the policy again. It is also important to take into account whether the increase would exceed the maximum amount allowed on the policy and appropriate advice should be sought.
How much does index-linked Income Protection cost?
Indexation can increase the initial premium by a small amount if selected but in the long term means your policy will reflect the changing cost of living. As with all insurance, the cost of the premium initially depends on your personal circumstances and on a variety of factors, including your age, occupation and payment period.
You do have the option each year to decline an increase due to indexation if you feel that either the increase is not beneficial or, in the case of a policy based on the maximum allowable, an increase would mean you would not be able to claim on the full benefit of the policy. As always, you should get advice to ensure any income protection policy applied for is appropriate for your circumstances.
Please note age-costed and reviewable premiums are not index linked. Instead these will increase on the anniversary of the policy, the 1st of January each year or on your birthday depending on the provider. Age-costed will increase by a pre-determined amount each year and the increases will get bigger each year as you get older and the risk of the policy increases. Reviewable premiums will be based on various factors including market forces and age and the increases are not pre-determined which means there is no guarantee as to how much this changes the policy.
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