Wouldn’t it be great if your income never stopped, even if you were seriously injured or too sick to work? I’m not talking about some generous, benevolent gesture from your employer, or the kindness of strangers, your family, or your community. I’m talking about a guaranteed, reliable way to keep your income flowing. The good news is, such a product does exist, and it’s called long-term disability insurance (LTDI).
What does it do?
- LTDI replaces your take-home pay (roughly 60% of your salary) if you’re unable to work because of an illness or injury.
- The policy can also be designed to protect and replace bonus income, retirement plan contributions, and future raises.
Why should you get it?
- Your home: Almost 50% of all foreclosures are typically caused by long-term disabilities that were triggered by illness or injury. Medical problems contributed to half of all home foreclosure filings in 2006. (Get Sick, Get Out: The Medical Causes of Home Mortgage Foreclosures, Christopher Tarver Robertson, Richard Egelhof, & Michael Hoke; August 8, 2008)
- Your family: You have an obligation to protect them. This means that if your income is paying the rent or mortgage, and the bills, then it’s irresponsible not to have any coverage.
- Your goals: Think about it. If buying a house, saving for college, and funding your retirement all rely on your ability to work and earn income, then why on earth would you not protect that income?
Item #1 above references a widely cited study published in 2008, which analyzed foreclosure filings from 2006. You may think that 2006 data are stale at this point, but it’s a perfect time period to analyze, because it occurred before the real estate bubble burst. By that I mean that data aren’t clouded by the other leading causes of foreclosures that occurring after 2007 (too much house, lax lending standards, underwater loans, etc. – a.k.a., the financial crisis).
Let’s carefully explore Item #3 above – your goals. As a financial planner (who does sell disability insurance), here is my perspective on the matter, and what I advise my clients:
If you rely on the income from your job to fund current expenses and future goals (like buying a home, funding college, and saving for retirement), then protecting that income should be the absolute #1 priority of your financial plan. It should form the very foundation of your plan.
I would suggest that it’s more pressing than building up you emergency fund, by which I mean that you shouldn’t wait until you have your three months of living expenses in the bank before you get your disability coverage in place. An emergency fund can only get you through a certain number of months.
A long-term disability policy can get you to retirement. Would you rather be covered for 90 days or 25 years?
Should you own your own policy, get your coverage through work, or both?
The short answer is, “It depends.” If you work for a company that provides long-term disability insurance as a group benefit (not all employers do), then you have the choice to enroll (if you’re paying for it), or enrollment could be mandatory (if the employer is paying). If you’re given the choice, it pays to look closely at your employer’s group policy to determine whether to use that one, or to buy your own policy. A couple of things to keep in mind:
- If you change jobs frequently, it almost certainly pays to get your own policy because typically, a group policy isn’t “portable” – you don’t get to keep it if you leave your job. Plus, if you move from a large company (with a strong benefits package) to a smaller company or start-up (with no benefits), then you’ll likely lose coverage.
- If you enroll in your employer’s group policy, and they pay the premiums, then the disability benefit is taxable (meaning, you should consider getting a supplemental policy to replace the benefit amount that you’d lose to income tax). For example: You have $100,000 annual gross income, and enroll in your employer’s plan, which replaces 60% of your income: $60,000 or $5,000 per month. That should pretty much replace your take home pay, but if your employer pays the premium, then you’ll pay federal and state income tax on the benefit. This means that your $5,000 monthly benefit could shrink to around $3,750 if you’re in the combined 25% tax bracket. In this case, you can get an individual policy to insure the $1,250 monthly benefit that you lost to income taxes. When you pay the premium, the benefit is income tax free.
What are some policy features to look for?
Policies vary widely in quality and generosity, so within a policy, you’ll have basic features like the “Definition of Disability” or “Benefit Amount” and “Benefit Period”. Other, optional features are called “Riders”, and some are more valuable than others. Here’s a quick tour:
Definition of Disability: The definition represents whatever criteria you need to meet in order for the insurance company to consider you disabled, and for them to pay your benefit. Generally speaking, there are two different definitions:
- Own Occupation: Because of an illness or injury, you’re unable to do the material and substantial duties of your own occupation. This definition is generous (and more expensive), because it means that if you’re no longer able to be a surgeon, for example, but earn money lecturing at the local university or as an author – or both, your policy will still pay you based on your inability to do profession #1 (surgeon).
- Any Occupation: Because of an illness or injury, you’re unable to do the material and substantial duties of any occupation (for which you are reasonably qualified – meaning they’ll consider your previous compensation level, training, education, and experience). If they determine that you can perform a different job, they may stop paying your benefit.
- Hybrid Definition: Some group policies use the “own occupation” definition for 2 years, and then shift over to the “any occupation” definition.
Benefit Period: This is the amount of time, measured in years that the policy will pay you for a given illness or injury. Common benefit periods are 2, 5, 10 years, and “to age 65” or “to age 67”. Policies with shorter benefit periods cost less (i.e., the annual cost of a policy with a 5-year benefit period will be less expensive than a policy with a benefit period that pays out until age 65 or 67). The shorter benefit periods are per-unrelated illness or injury. So, if you file a claim because of a car accident, and recover, then later file a claim because of an illness, the 5 year clock starts again from day one.
Protecting Bonuses: Typically, a long-term disability policy replaces 60% of your base salary. However, for some occupations, much of the compensation is in the form of incentives and bonuses. In these scenarios, the insurance companies will usually cover the average of the last two years of bonus compensation. (Example: Year 1 bonus = $100,000; Year 2 bonus = $50,000. Bonus Coverage = $75,000). The key here is to get the most coverage for which you qualify, and every year, revisit your coverage levels to see if you financially qualify for an increase in coverage.
Protecting Future Salary Increases: Speaking of salary increases, what if you get a big raise that you want to protect? Can you just sign up for more coverage? Absolutely. There are two options:
- Simply apply for more coverage. It would be a new application, and a second (or third, etc.) policy. This approach requires financial and health underwriting again. So, you’ll be providing access to your medical records, and taking another medical exam to get the new policy.
- On your initial disability policy, elect a rider (feature) called “Future Insurability Option” or “FIO”. This rider allows you to apply for more coverage after that big raise, but with no medical underwriting. Bottom line: it protects your insurability, so that if, after securing your initial policy and coverage, you are injured or get a health condition that would otherwise render you “uninsurable”, you can still buy the additional coverage. This is a powerful feature. Even if you damage both knees, and are diagnosed with diabetes and asthma (after securing your first policy), you can increase your coverage if you have elected the FIO rider. Under Option #1, you probably would not get the policy if your were deemed “uninsurable”.
Elimination Period: This is the amount of time, measured in days, during which you need to be disabled until the policy begins to pay your benefit. Generally speaking, the optimally priced option is 90 days. However, you’re welcome to select (and pay for) many, many other options: 30, 60, 180 days…
Non Cancelable & Guaranteed Renewable: This is a critical policy feature. It ensures that your policy will not change (i.e., the terms, cost, your benefit amount, or other policy riders) for as long as you keep the policy active by paying your premiums.
Residual Benefit: This benefit pays a pro-rata amount of your income during that transitional period when you’re back at work, but not quite full time, and not earning your full, “pre-disability” income. Some formulas are based on a loss of income; others are based on a loss of time.
Retirement Protection: If you have been contributing to your retirement plan, you can get a policy that will, during a period of disability, make similar contributions into a tax-deferred retirement account on your behalf.
Inflation Protection (COLA, or Cost of Living): This rider helps to ensure that your benefit is adjusted annually to keep pace with inflation after you file a claim. Some options are more expensive than others (e.g., 3% simple interest, 3% compounded interest, 5% simple, 5% compounded, etc.). In lieu of this option, some policies automatically increase your coverage amount every year, whether you have filed a claim or not.
Taxation of the Benefit: If you pay the premium, the benefit is income tax free. If your employer pays the premium, the benefit is subject to income tax.
How do you get it?
You can work with an insurance broker or agent to apply for a policy. Brokers can work with multiple insurance companies, whereas Agents typically only work with one insurance company. Qualifying for disability insurance depends on a number of factors (as does the cost, which we’ll discuss below).
- Job classification: Depending on the nature of your work, a disability insurance company will assign you an “Occupational Class”. Simply put, different jobs are placed into different risk “baskets”. The carriers tend to prefer those who work in white-collar environments (attorneys, physicians, accountants, etc.), and price the coverage accordingly. Not so much those with more physically intensive professions that carry with them a greater risk of injury (jack-hammer operator, bridge maintenance worker, international man of mystery, etc.). This classification is necessary, although it does bear noting that 90% of extended disabilities are caused by illnesses, not injuries. However, since the insurance company is on the hook to replace your income for many years – potentially millions of dollars – they need to carefully assess you as a risk.
- Medical Underwriting: You will disclose your medical history by answering questions on the application, taking a medical exam, and by giving the insurance company permission to review some or all of your medical records.
- Financial Underwriting: You will also disclose your year-to-date earnings (on the application and/or with a pay stub), and the past two years of income (on the application and with a W2 or federal tax return).
What does it cost?
The cost of a policy can vary considerably, depending on your age, gender, benefit amount, profession, and riders or features discussed above. But if you agree that you need coverage, you can always structure a policy so that it meets your budget and circumstances. To help reduce the cost, several components can be adjusted:
- Benefit period: The shorter the benefit period, the less expensive the policy.
- Inflation protection: This rider can be pricey. You may decide not to get any inflation protection, and instead just get some basic coverage in place.
- Exclusions: Specific health issues don’t necessarily make the policy more expensive, as is the case with life insurance. What the insurers tend to do is to exclude coverage on disability claims that may be caused by certain pre-existing conditions. But, they’re very specific about any exclusions, and fully disclose it in the insurance policy contract. Example: you’re an otherwise healthy physician, and spend a lot of time on your feet at work every day. The only significant red flag in your health history is an old ski injury on your left knee. You will likely get a great policy at a competitive price, but they’ll specifically exclude any coverage for a disability caused by that knee injury. If you are then in a car accident that seriously injures the same knee, the policy will pay. But if you stop working because of the knee injury, it won’t pay. Exclusions can usually be removed from a policy if you can prove that there have been no symptoms or treatments for two or three years.
What are the risks of waiting?
- Financial: The most serious risk of waiting to apply for coverage is that you suffer a long-term disability before you have the coverage. This risk could be financially devastating, put you into serious debt, and derail the savings plan for your future goals.
- Insurability: Another risk is that before (or during) the application process, you suffer an injury, illness, or combination of both that renders you “uninsurable”, meaning that no insurance company will offer you coverage.
- Cost: Every year as we age, it gets more expensive to purchase coverage.
Here’s the bottom line: Do yourself and your family a favor, and don’t rely on the kindness of strangers. You might get a benefit concert or two at the beginning, but let’s face it. Getting from here to there (i.e., house, college, retirement) – replicating 20 or 30 years of your earnings – costs a LOT of money. Better to have an institution pay the bill, than your friends, family, or community.
Daniel D’Ordine, CFP® is the owner of DDO Advisory Services, LLC, a full service financial planning and investment advisory firm in New York City and Rhinebeck, NY.
Follow me @DDOadvisory.