Opportunities for product development in the realm of income protection have arisen on the back of the trend for employers to switch from defined benefit to defined contribution pension schemes. In the good old days when defined benefit schemes had fat surpluses they could – trustees permitting – often provide generous pensions for members who had to stop working early as a result of ill health.
But because this cannot be done with defined contribution schemes, which are structured differently, the idea has been mooted that employers with defined contribution schemes should be interested in using income protection to fill the gap.
If the opportunities are genuine, the boat clearly remains very much in the harbour. Findings from a National Association of Pension Funds (NAPF) survey released this January show that 52 per cent of defined benefit pension schemes currently open to new members could close as a result of the current economic crisis. 24 per cent of schemes which remain open to new members and 27 per cent which are closed to them also intend to switch existing members to some form of defined contribution or hybrid/career average scheme.
Nevertheless, opinion is notably divided on how much income protection business has ever been or is ever likely to be sold to meet this ill health early retirement niche. Most insurers acknowledge that they have little way of knowing what proportion of their new income protection business during recent years has resulted from this source, and intermediaries can cite anything from “under 10 per cent” to “the vast majority”.
Part of the problem is that it has always been notoriously difficult to get any worthwhile figures on the extent to which the defined benefit schemes themselves ever granted ill health early retirement.
Bob Free, national business development manager at Canada Life, says: “It isn’t really clear how much defined benefit scheme trustees ever spent on ill health early retirement, and there is plenty of anecdotal evidence to suggest that the system was abused as a means of getting rid of dead wood. Some of the recipients weren’t ill and wouldn’t have passed an income protection insurer’s criteria for a claim.”
Those intermediaries who have written significant amounts of group income protection business on the back of ill health early retirement needs stress that the sales process is far from plain sailing. Employers switching away from defined benefit schemes are trying to reduce costs so they tend to be reluctant to consider additional expenses.
Carlos Correia, senior consultant, risk benefit unit at Lane Clark & Peacock, estimates that at least half of his company’s group income protection cases are in some way related to ill health early retirement – a reflection of the fact that it deals with a lot of defined benefit schemes.
He says “The ill health early retirement aspect is only a small part of the cost but it can be a long way down the list as employers tend first to concentrate on retirement considerations. They might remember life assurance but will not normally focus too much on ill-health. This could be a general reflection on the current lack of awareness of the importance of group income protection, and some employers can also have strong reservations about income protection. If they have a blue collar workforce it could be expensive to cover them and the employer might not want to keep sick staff on the payroll for a long time.”
Some employers do change their tune further down the line when they actually experience an incidence of an employee who needs to be retired early on health grounds, but even in these cases there can be reservations about the fact that income protection does not provide an exact substitute for a defined benefit scheme’s ill health early retirement facility.
Income protection will normally pay out until the employee’s intended retirement age – as opposed to until the time of their death – but because claimants remain on the payroll their pension contributions will usually be paid, and the pension will therefore take over at retirement age. Nevertheless, only employees who are genuinely incapacitated will be able to claim under income protection and, because insurers have invested so heavily in early intervention and rehabilitation facilities, the individuals concerned could soon return to work.
All this may not go down well with employers accustomed to retiring people early on health grounds if their face didn’t fit, in the knowledge that defined benefit pension scheme trustees were unlikely to review the health of the individuals concerned regularly, if at all.
Even when group income protection is wanted to plug the ill health early retirement gap, both insurers and intermediaries disagree markedly as to whether standard income protection schemes are proving more popular for the purpose than other newer formats.
Some point to demand in this area for income protection schemes that pay out for only a limit period of two to five years. These can greatly reduce insurance premium costs and, because the employee will be removed from the payroll, the employer will no longer have to make NI and pension contributions. Others report greater demand for short-term schemes offering capital options – lump sums at the end of the benefit term that employers can, if they wish to, use to boost the employee’s pension fund.
A further popular option is the Pay Direct facility, which some insurers provide as a contractual entitlement but others offer only if they feel it is in the interests of the relevant parties. It involves the employee receiving benefits until retirement age but being removed from the payroll. A proportion of the benefit received can be used for making pension contributions.
Alan Thacker, senior consultant at Buck Consultants, says “Different companies have different requirements but there is a full range of options to suit all tastes. At the same time there is a real danger of employers not looking at them all because they feel they can’t afford them. Many paternalistic companies wouldn’t want to sever employment but Pay Direct can suit the less paternalistic ones wanting to offer a decent benefit. Those that can’t meet the costs of this may prefer a two year benefit period and, if they can afford it, a capital option.”
Legal & General’s launch this January of its Workplace Recovery has provided a further alternative, although this could be seen as an exercise in commoditising features already widely available on a tailor-made basis. Employers can reduce cover costs by around 50 per cent over standard group income protection by opting for a definition of activities of daily working – which only pay out for the more severely disabled.
Jamie Winter, head of healthcare and risk consulting at Watson Wyatt, says “The broader industry has missed the design boat and Legal & General has tried to address this by packaging up some of the newer income protection ideas. I welcome this but my concern is that they are marketing it as an ill health early retirement product. Genuine ill health early retirement is payable for life but this only pays until retirement age.”
Virtually any appropriate cover that works out cheaper than actually funding genuine ill health early retirement can in theory provide a useful alternative, and this could include income protection offered via flex and even voluntary schemes. But, as the economy continues to worsen, the less costly income protection formats are likely to grow in appeal anyway and this January’s ruling by the European Court of Justice that the long-term sick don’t lose their right to holiday pay could increase their appeal further.
So, although sales of the less costly income protection formats could increase during the forthcoming round of defined benefit pension scheme closures, it is unlikely to be clear whether this has resulted primarily from ill health early retirement or from other considerations. Even if the boat remains in the harbour, it won’t necessarily be plain sailing.
The importance of getting in early
Katharine Moxham, consulting director, health and risk, Jardine Lloyd Thompson
Katharine Moxham, consulting director, health and risk, at Jardine Lloyd Thompson (JLT), thinks that ill-health early retirement is likely to be a significant driver for group income protection sales going forward, but stresses the importance of broaching the subject at the actual time of the pension scheme switch.
She says: “You have to get the costs involved into the restructuring and, if you do so, there are big opportunities but it’s no good going along and trying to sell income protection afterwards. You have to budget for the extra spend at the point of the defined benefit scheme switch and there are ways of achieving savings by looking at other group risk products, private medical insurance (PMI) and wellbeing and absence management solutions. In my experience when I’m able to release pockets of money from elsewhere the line of resistance to income protection is very low.”
Moxham feels that intermediaries have missed opportunities for ill-health-early-retirement business as a result of pension consultants being separated from group risk operations. But she points out that the restructuring of many of the major intermediaries should enable them to take a more integrated approach going forward. “JLT has taken on a number of consultants who deal in employee benefits across the board and people like myself are working more closely with the pensions experts. So in every instance we should be able to advise around the need to replace ill-health-early-retirement.”