Dead reckoning

Funeral insurance can be a deadly financial trap … one alternative is a simple cash account.

PORTFOLIO POINT: Funeral insurance policies generally have ‘stepped’ premiums, so the longer you live the more costly they become. Setting money aside in the bank will give better peace of mind.

One of the more heavily advertised financial products at the moment is funeral insurance. Daytime TV, particularly, seems to be filled with ads for various companies promoting funeral insurance. This is an insurance that is marketed at older Australians, as a way of paying for their funeral. Much like any insurance a regular premium is paid, and a lump sum is paid at death to cover the costs of the funeral.

Funerals are an important item to think about. The website moneysmart.gov.au, a federal government site with a range of financial information, suggests that the cost of a funeral is between $4,000 and $15,000. This is a significant amount of money, and the ads focus on the need to have this money available to pay for a funeral, alongside the emotional message that people should not put their families under financial pressure at the time of their death.

It goes without saying that people taking out funeral insurance are doing it from a position of genuine concern for their family and friends – however a close look at how funeral insurance works suggests this may not be the best way to go about it.

ASIC concerns

ASIC has stepped into the debate with a report looking at how funerals are paid for, entitled ‘How Will You Pay for Your Funeral?” The report was based on a study of a small number of people who actually had funeral insurance, and suggests a number of concerns for consumers of funeral insurance including:

  • Many people got their information from TV advertising (which is not a great source of unbiased information).
  • Many people do not understand how the premiums rise over time.
  • They often buy the first insurance they see, rather than compare.
  • The don’t understand the difference between stepped premiums (that rise every year) and level premiums (that start at a higher rate but don’t rise).
  • They don’t understand the total cost they will pay in premiums over the life of a policy.

The structure of funeral insurance

Funeral insurance is similar to most insurance policies in that it has a premium and a benefit. The premium is the regular payment to keep the insurance in force. The benefit is a lump sum, promised to be paid quickly in the event of your death to pay for your funeral, and usually an amount from $5,000 to $20,000.

The big problem

The big problem for consumers is that the premiums for most funeral insurance rise over time. These are known as ‘stepped’ premiums, and each year increase as the risk of death increases. The alternative to ‘stepped’ premiums is ‘level’ premiums. These don’t increase over time, so the person with the insurance policy has some certainty about how much they are paying.

The use of ‘stepped’ and ‘level’ premiums also exists with general life insurance policies, and they are something consumers should be aware of. The ‘stepped’ premiums will always start cheaper (whether life insurance or funeral insurance), however you should always check how much they will cost over the life of an insurance policy.

The TV ads often emphasise the low initial costs of the insurance – for example using the phrase ‘less than the cost of a cup of coffee every week’. The sting, however, is in the way the insurance premiums increase.

One funeral insurance provider advertises cover starting at $3.41 per week for $6,000 of insurance cover (for people aged 17 – 44), however by age 65 it had risen to $9.48 a week, and by age 82 the example premiums were $29.70 a week. Keep in mind that $29.70 is equal to $1,540 per year – for a plan with a $6,000 benefit. To put this another way, for a single aged pensioner this is getting close to 10% of the single aged pension – just for their funeral insurance.

The same provider offers ‘level premiums’ of $8.37 for $6,000 of cover if taken out at age 60. By the time you are age 74, well short of the life expectancy of a person aged 60, you will have already paid more than $6,000 in premiums for $6,000 of insurance cover. This does not include the investment earnings you would have made if, rather than pay premiums for funeral insurance, you deposited this money into some sort of investment.

The trap – Stop paying and lose it all

However, it is the more common ‘stepped premiums’ that provide the greatest trap. Because it is an insurance policy, once you stop paying you are left with nothing. So, as the policy increases over time the person with the policy starts to feel increasingly trapped. They have paid thousands into the policy, the premiums keep increasing until they become increasingly unaffordable, but if they stop paying the premiums they end up with absolutely nothing.

The alternative – A simple cash account

My strong opinion is that it is far better to build a cash reserve, part of which can be used to pay for a funeral, than to take out a funeral insurance policy. For extra peace of mind, check with your bank as to how they release money from your cash account for a funeral when you pass away.

The benefits of simply building some cash investments to pay for a funeral include:

  1. You keep the cash account interest that is earned.
  2. If another emergency arises, the funds can be used for that (e.g. medical costs).
  3. You are not penalised by losing the insurance if you stop paying premiums (in this case the money into your cash account) for a while.
  4. You are not subsidising the significant advertising and profits of the companies providing funeral insurance.

The information consumers need

The ASIC report certainly pointed toward the information that consumers need – the total cost of premiums over the lifetime of a funeral insurance plan. This should be easy to put together. Using life expectancy tables, funeral insurance providers should be required to calculate the total premium costs for anyone taking out funeral insurance at their current age, assuming that they live to their life expectancy.

They should also calculate the total premiums assuming that they were invested in a cash account earning interest of 5% a year. These two figures should be compared against the funeral benefit – giving consumers a great insight into whether they are getting value for money.

Let us look at how that might work in reality. I have used the premiums for a $6,000 funeral benefit from a well-known funeral plan provider. For a person taking out funeral insurance at age 60, their life expectancy is 22.6 years (male) or 26 years (female).

Based on their policy with stepped premiums, the premiums for a male would be $19,000 (for an initial $6,000 benefit). When 5% interest is earned on the premiums, that amount foregone (premiums paid and interest that could have been earned) would be $30,800. Assuming inflation of 3% a year, the funeral benefit would have increased to $11,750 in 22.6 years time (in the stepped plan, benefits increase with inflation).

The premiums for a female (who would live a little more than three years longer) would total $25,000 and, when 5% interest is factored in, the amount foregone will be $44,100 (for the $6,000 benefit). Assuming inflation of 3% a year, the funeral benefit would have increased to $12,950 in 26 years’ time.

Simple graphs would be useful for people in understanding this data. For example, you are considering taking out a funeral insurance plan. As a 60 year old female, your average life expectancy is 26 years. The following graph represents your insurance benefit, premiums paid and possible by the time you reach your life expectancy (age 86).

Conclusion

It is important to think about how you will pay for your funeral. However, for most people with even modest levels of assets, it is likely that a talk with your bank manager about how cash can be accessed in the event of needing a funeral will be all that is needed to put your mind at ease. Funeral insurance will be an expensive and unneeded financial product for most people, despite the ‘peace of mind’ slogan that is so heavily advertised by insurers.


Graph for Dead reckoningScott Francis is an independent financial adviser based in Brisbane.