Kevin Michels, CFP®, EA
Let me start out with a disclaimer and an important note: As a fee-only financial planning firm we don’t sell insurance or receive any type of third-party compensation on the recommendation and implementation of insurance policies. However, that doesn’t diminish the importance of insurance, and when it comes to investing, one of the principles we tell our clients to abide by, is to have their risks covered before they begin/continue investing.
That means having an adequate amount of cash stored away for emergencies as well as having the proper insurance policies and coverages in place to protect you from financial ruin in the case of a financially catastrophic event happening.
As we go through the financial planning process with clients and review their insurance policies, the most common deficiency we encounter is a lack of proper disability coverage, or an absence of it altogether.
Data regarding the probability of becoming disabled during your working years is all over the map, however, one point the data is clear about it is that you are much more probable to become disabled than you are to die prematurely. Yet, it is much more common for people to have life insurance than it is to have disability insurance (granted, depending on the disability, the financial impact of a premature death is much more substantial than becoming disabled).
In fact, outside of our physician clients and clients who have a disability policy through work, I’ve rarely ever done planning for someone that had an existing disability policy in place. This may be attributable to ignorance but even more so towards the fact that disability insurance can be complicated and hard to navigate. Wading through the different types, terms, benefits, lengths, and everything else associated with disability policies can be frustrating.
In the end, ensuring you get the correct policy for you and your unique situation is extremely important. In this article, we’ll simplify the intricacies of disability insurance and hopefully provide some clarity on which type of policy is right for you.
Long-term disability insurance usually comes in two different types, own-occupation or any-occupation.
An own-occupation disability policy pays out a benefit if the insured is unable to perform the material and substantial duties of their own particular occupation. An example of this would be a surgeon that loses his eyesight and becomes completely blind. In no circumstance would this surgeon be able to perform the “material and substantial” duties of performing surgery, which means he would be eligible to receive his disability benefit.
Some policies are defined as transitional own-occupation. These policies will decrease your benefit if you earn income through a different job after becoming disabled. For example, if the surgeon that went blind was entitled to a $15,000 monthly disability benefit but went back to work as a pharmaceutical sales rep earning $8,000 monthly, his disability benefit would be reduced to $7,000.
An any-occupation disability policy only pays out a benefit if the insured is unable to perform duties of any gainful occupation that the insured is reasonably suited for based on their education and experience. However, that doesn’t mean that the surgeon is entitled to benefits just because he can’t perform a job in the medical industry. The surgeon will only be entitled to benefits if he can’t work any gainful occupation. That means that under an any-occupation policy, if the surgeon is able to work at a fast-food restaurant or at a toll booth, he isn’t entitled to his disability benefit.
Many employer-sponsored plans offer a hybrid of own-occupation and any-occupation. Usually, it will be structured so that the first two years after your disability, the benefit is paid out on the own-occupation clause. After two years, the benefit will be paid out on the any-occupation clause. Statistics show that the average disability benefit is paid out between 2 to 4 years before the the insured is able to return back to work. In this case, the hybrid policy would be beneficial. For example, let’s assume the surgeon owned a policy that only paid out a benefit under own-occupation for two years and then switched to any-occupation. The first two years he would be eligible for his $15,000 monthly benefit, after which the benefit would stop since he could perform a variety of other occupations, even though they may be out of his scope of education and experience and pay much lower.
In addition to the two general types of disability policies, you’ll want to keep an eye out for these terms:
- Non-cancelable – A non-cancelable policy is a policy that the insurance company cannot cancel, increase the premiums on, or reduce the benefits, as long as the insured pays their premiums. This is important for a few reasons. If you go from a very low-risk job, like working in an office, to a very high-risk job like a construction worker, your premiums cannot be increased. In addition, if you go from a higher-paying job to a lower-paying job, your benefit cannot be decreased either.
- Guaranteed renewable – A guaranteed renewable policy is a policy that the insurance company cannot cancel if the insured continues to pay their premiums. However, the insurance company does have the right to increase premiums based on the filing of a claim or a higher risk occupation.
- Conditionally renewable – A conditionally renewable policy basically gives all the power to the insurance company. They have the right to cancel the policy at any time if certain conditions are met (such as moving from a low-risk job to a higher-risk job), even if the insured has paid their premiums. They also have the right to raise premiums and/or lower the benefit amount.
Just like most things, you get what you pay for. An own-occupation policy will be more expensive than an any-occupation policy. And a non-cancelable, guaranteed renewable policy will be more expensive than a conditionally renewable policy. However, the last thing you want to deal with after becoming disabled is fighting with an insurance company or not getting your benefit at all.
Length of Benefits & Elimination Period
The benefit period for disability insurance is categorized generally as either short-term or long-term.
Short-term disability policies usually pay benefits up to 3-6 months; however, some policies will offer benefits up to two years. Both short-term and long-term policies include an elimination period, which is a set amount of time before the policy will begin to pay your benefit. The elimination period works similar to a deductible in a health insurance policy. It requires you to have some “skin-in-the game” and cover your own expenses for a period of time before the benefit kicks in. Short-term disability policies usually have a 14-day elimination period.
Unless your employer offers short-term disability insurance at no cost or substantially subsidized, we usually recommend our clients forego short-term disability insurance. One of the purposes of having an emergency fund of 3-6 months is to cover you in the case of a short-term disabling injury.
Long-term disability policies pay benefits anywhere from 2, 5, 10 years, or until retirement. The most common and cost-effective elimination period of a long-term disability policy is 90 days but can range anywhere from 30 to 720 days.
Benefit Amount & Taxation
Most long-term disability policies cover 50% to 60% of your income but can go up to 80%. If the premiums on your policy are paid by your employer, the benefits will be taxable. If you purchase the policy privately and pay the premiums yourself, the benefits will be tax-free. While having a benefit of only 50% - 60% of your income may not seem like enough to cover your expenses, it usually is. Consider someone who was making $100,000 before becoming disabled and owned an individual disability policy. Between payroll (7.65%), federal (12%), and state (5%), they’re most likely paying around 25% in taxes. Add in an additional 10% for their 401(k) contributions and their take-home pay is around 65% of their gross income. If the insured is able to work another job that is less physically demanding, and the policy is non-cancelable, guarantee-renewable then the insured may very well make-up what they were earning pre-disability.
If your disability is serious enough to qualify for social security disability benefits, the benefit you receive from your disability policy (or workers compensation if the injury happened while at work) could be reduced by the amount you receive from your social security disability benefit. The most generous policies do not include a provision that reduces your disability benefit, however I’ve seen policies that offset your disability benefit by the amount you receive in social security disability benefits dollar-for-dollar. The average, or most common policy caps your total disability benefits at 80% of your pre-disability income.
As you’ve probably gathered, the cost of disability insurance can vary greatly depending on the following factors:
- Policy type (own-occupation versus any-occupation)
- Terms (non-cancelable, guaranteed renewable, conditionally renewable)
- Length of benefits
- Length of elimination period
- Benefit amount
- Group versus individual policy
- Subsidized by your employer or not
- Age, health, where you live, and occupation
As a point of reference, a healthy 45-year-old with an office job making $150,000 of income per year could expect to pay anywhere from $1,500 - $2,000 per year for the following private policy:
- 5-year benefit period
- Own-occupation for two years, any-occupation all subsequent years
- Non-cancelable, guaranteed renewable
- 90-day elimination period
- 55% income replacement
The premiums on this policy would cost roughly 1% of this person’s income. However, if they wanted a higher income replacement, longer-benefit period, or an own-occupation clause for the entirety of the benefit period, the premium would be higher. Keep in mind, this is for a private policy. Group policies are traditionally cheaper, and much cheaper (or even free) if subsidized by your employer.
Disability insurance is an often-over-looked part of an individual or family’s financial plan. Whether you have coverage through your employer or individually, make sure you understand the ins-and-outs of the policy (ask for a summary plan description), so you can know what to expect if you ever become disabled. The most widely-known statistic is provided by the Council for Disability Awareness that states 25% of today’s 20-year-olds can expect to be out of for at least a year because of a disabling condition. http://disabilitycanhappen.org/disability-statistic/.