Income protection: The ultimate rainy day fund

Helen Inkster and her two boys. The inksters have taken out income protection insurance. Picture: TSPL

The extent to which ordinary Scots are vulnerable to financial meltdown has been set out in a stark new report on the threats to household finances.

Clearing debts and putting rainy day savings aside have been the name of the game in recent months as households have sought to bolster their buffer against hard times.

Yet very few have sufficiently strong safety nets to survive financially in the long-term in the event of being hit by illness, accident or unemployment.

The warning came in the latest annual Scottish Widows Protection Report, published this week, which found that more than half of Scottish homes with at least one wage earner rely on a single income to make ends meet.

The loss of that income could prove financially catastrophic, particularly for those without savings or insurance in place.

A fifth of homeowners quizzed by Scottish Widows said they would soon struggle to pay their mortgage if they were to lose one or more household incomes, while one in three would find it difficult to pay other regular bills.

More than half of Scots of working age fear they would run out of money within six months if they were to lose their main income.

It’s a perilous state of affairs that reflects the ongoing squeeze on incomes, as redundancy, pay cuts or wage freezes and the government’s latest spending cuts add to the pressure on household finances.

Those factors, allied to a chronic shortage of decent savings accounts, make it increasingly difficult for households to save sufficiently to stave off financial hardship.

A third of Scots surveyed by Scottish Widows revealed that they’re not able to save any money at all, above the UK average.

The problem is exacerbated by what’s known as the “protection gap” – the difference between the insurance cover that people would ideally have and what they actually have in place.

Take-up of insurance policies that are designed to replace a lost income remains distinctly low, despite high awareness of the products.

The best-known such cover – and the one financial advisers consider most valuable – is income protection.

But while 84 per cent of people in Scotland have heard of it, just 5 per cent have income protection in place. That leaves the vast majority badly exposed financially in their household in the event of losing one or more incomes.

Income protection is favoured by advisers due to the regular income it provides to help cover mortgage payments, bills and other household essentials. It typically pays out between 50 and 65 per cent of your stated income if you’re unable to work and can do so for as long as needed. The policies ostensibly provide cover if you’re unable to work because of illness or an accident, but unemployment can included as an “add-on”.

There are also exclusions that make some people ineligible for the insurance. These include pre-existing medical conditions; pregnancy; misuse of alcohol or drugs; disabilities or illnesses arising from involvement in criminal acts, war, riots, invasion or, terrorism; and self-inflicted injuries. Certain risky occupations can also make it difficult to secure insurance.

Yet it should be high on the must-have list for anyone wanting to protect their families from the financial implications of being unable to work, claimed Carl Melvin, director of Affluent Financial Planning in Paisley:

“It’s absolutely essential to have this protection, it’s the most important insurance protection priority,” he said.

The damage to family finances that long-term illness or disability can cause are widely underestimated, he believes.

“Employment support allowance at only £71.70 per week is pitiful and would quickly result in financial problems. The loss of earned income would devastate most families,” said Melvin.

“Even for those with decent sick pay it is reduced after six months and then there’s nothing after 12 months.

“In light of the reforms to the benefits system it’s clear that individuals need to take responsibility for protecting their income – otherwise you deal with the consequences.”

Of those surveyed by Scottish Widows who had been diagnosed with a serious illness, a quarter had been forced to make drastic changes to their lifestyles to cope with the financial consequences. Just one in 20 had income protection insurance, while 9 per cent had critical illness cover in place.

The main reasons given for not taking out the insurance include a lack of trust in the insurance industry, cost and the belief that it wasn’t necessary.

Katya Maclean, protection experts at Scottish Widows, said that while those objections are valid, many people also elect to ignore the threats to their finances.

“No one likes to think about the unexpected happening to them, yet it is clear that this tendency to ignore the worst case scenario is preventing Scottish families from preparing for the future and protecting their livelihoods,” she said.

Case study: Planning ahead for peace of mind

When you’ve got two kids, another on the way and a husband in the Merchant Navy, the prospect of losing the main household income can be a fearsome one.

So it was peace of mind that Helen Inkster was looking for when she recently took out Scottish Widows’ critical illness cover with life insurance at her local Bank of Scotland branch in Orkney.

“We bought it so that we could protect what we have in the event of something happening to one of us,” said Helen.

“We’d been planning to for a while but worried that it was too expensive. It’s difficult spending on something you don’t know you’ll need, but it’s worth it for the peace of mind.”

Critical illness insurance is designed to pay out a lump sum on the diagnosis of a serious condition such as cancer, heart attack or a stroke. With Angus just two-and-a-half-years old, Murdo one year and another child due in September, it’s a while before Helen expects to be working again. Husband Murray spends part of the year away from home, adding to the potential difficulties if serious illness were to strike.

The economic climate contributed too, adding to the pressure on household finances.

“The cost of living is going up and it doesn’t take long without an income to be in financial difficulty,” Helen pointed out.

“We have savings, but they are for a rainy day, for moving house, to help the kids through college and so on, you hope you don’t need that money for day-to-day living.”

How to buffer the shock

• Face up to your debts. Write down what you owe – including mortgage, credit cards and overdrafts – and prioritise the most expensive. Don’t be afraid to seek help from free sources of debt advice such as your local Citizens Advice Bureau or the StepChange debt charity (www.stepchange.org / 0800 138 1111).

• Build a rainy day savings fund of three to six months net income, if possible. Around a third of Scottish households have no such savings, while many that do are being forced to eat into them to pay their bills. Inflation outstrips all but a handful of savings accounts, but that only makes it more important than ever to get the best possible return you can. Use comparison sites to search for the best savings deals, starting with Isas.

• Get covered. Income protection policies can provide an income in the event of being unable to work due to accident or illness (and unemployment where requested). Alternatively – or in addition – critical illness insurance pays out a lump sum on the diagnosis of a life-threatening condition. Payment protection insurance (PPI) may be the subject of the UK’s biggest-ever mis-selling scandal and it is far more limited than income protection. However, it’s still worth considering as a cost-effective, short-term alternative, provided it’s taken out on a stand-alone basis from specialist insurers.

• Prioritise the insurance you buy. You may feel more inclined to insure your mobile phone or pet, but the loss of an income would threaten all elements of your lifestyle.

• Get what you’re entitled to. Amid the furore over welfare spending, it’s forgotten that more money is left unclaimed than is paid out in benefits. Many people who qualify for payments including jobseeker’s allowance, pension tax credit, income support, child benefit and housing benefit fail to claim them. Visit www.turn2us.org.uk/benefits_search.aspx to check you’re getting what you’re eligible for.