For most of us, the largest asset is the ability to generate income in the future, what economists call human capital. We often make decisions as if that future income is a given, thinking we’ll earn as much or more in the future. What about the possibility that we may lose the ability to generate income, even temporarily? How often do we think about disability? Not very often, as it turns out.
Disability statistics
According to Social Security data, about one in four people can expect to be out of work for at least a year during their career due to a disabling condition. Most disabilities (90% or more) are caused by illnesses rather than accidents. Common causes of disability include musculoskeletal disorders, cancer, pregnancies, mental issues including depression and anxiety, and injuries. For disabilities lasting longer than three months, the chance that they will last at least 5 years is close to 40% and increases with age. The risks are higher for outdoor jobs that require physical work, for tobacco users, overweight people, people with medical conditions, or people with unhealthy lifestyles. The stats are clear on this: disability can happen to anyone.
Managing disability risk
A general principle in financial planning is to insure risks that have relatively low frequency but can have severe economic consequences. Thus, disability risk is a good candidate for insurance. Disability insurance provides periodic payments to replace income when someone is unable to work because of disability, sickness, or injury. There are two types of policies: short-term policies, with maximum benefits of two years, and long term policies, with benefits typically lasting a set number of years or until you reach age 65.
On short term policies and the first year or two of a long term policy, payments are made based on the inability to perform regular work duties due to injury or illness. This is the so-called ‘own occupation’ definition of disability. After the first year or two in long term policies, the definition of disability becomes stricter, and the policy will pay only if the insured is unable to perform the duties of any occupation.
Disabilities lasting less than a year have less severe consequences and can, depending on the situation, be self-insured. For example, the risk of a job loss is generally managed by building a safety net. If you have a safety net, and everyone should plan for one, you probably don’t need to purchase short term disability insurance. Given the severity of long term disability, however, long term insurance is generally worth the cost. Annual premiums range in the order of 1-3% of income.
How much do you need?
The calculation of the need is similar to the calculation of a safety net, with some additional adjustments. It’s important to understand your health insurance coverage and make sure you plan for a potentially higher cost due to deductibles and coinsurance expenses. Plus, because you are planning for a potentially longer-term disruption to income, the income from the insurance policy may be needed to contribute to longer-term goals, including retirement savings or your children’s education plans. Insurance companies typically limit the income disbursed to about 60-75% of your income, and even this can be subject to maximum limits. Many high earners may need to get the maximum coverage available to them.
Covered at work?
About 40% of people in the private sector have some form of disability insurance through their employer. If that’s your plan for disability, make sure you know how much you are covered for, and whether the benefit is taxable income or not. First your coverage. It’s common for group policies to cover 60% of your base income. If you make $300K a year with a $200K base plus a $100K bonus, your coverage would be $120K. In addition, this amount can be further subject to a maximum limit. Check your policy if it has a monthly or weekly max.
Generally, if you pay the premium with after-tax income, your disability benefit will be tax-free. This includes arrangements where the company pays the premium and you pay a tax on the premium payment. If your premiums are paid (either by you or the company) with pre-tax income, the benefit will be taxed. In the example above, a single individual with taxable benefits may end up with a net benefit of about $100K.
So make sure you know how much coverage you can expect from work before deciding whether you are really covered for your needs or not.
Buy more?
If you checked and your needs are greater than your coverage, get some quotes for additional insurance. Some companies may go above the 60% limit, and if you pay the premiums with after-tax dollars, you don’t have to worry about taxes on the benefits. It may be a good idea to have your own individual policy in the event you decide to change jobs. You normally lose your group policy if you leave your employer, and you need proof of income to get insurance. That’s particularly important if you plan to be between jobs for a while or plan to start a business down the road.
The simple long-term policy pays you a stated benefit for a specified period of time (a number of years or until retirement). Look for a non-cancelable policy, which renews automatically with the same premium every year. Long-term policies usually contain a so-called ‘elimination period,’ which is the time it takes before the insurance starts making the payments. For a long-term policy, this could be three months to a year. The elimination period is like the deductible in your auto policy. You are essentially asked to self-insure for part of the loss. The longer the elimination period, the lower the premium payment. Make sure you can count on a safety net to cover for that.
Some common benefits or ‘riders’ that can be added to the policy include a cost of living adjustment or COLA, which means your benefit will increase annually by a specified percentage, and a partial disability rider, which pays a percentage of the full disability amount (usually 50%) if you can return to work on a limited or part-time basis.
Disability Insurance vs Workers Compensation and Social Security
You may know that the Social Security program can pay benefits in case of disability. However, the Social Security definition of disability presents a high threshold: “Disabled means inability to engage in any substantial gainful activity as a result of medically determinable physical or mental impairments that can be expected to result in death or to last for a continuous period of not less than 12 months.” So Social Security disability is not a substitute for private disability insurance.
Disability insurance policies typically exclude work-related injuries that are covered by workers’ compensation. Employers participate in workers’ compensation programs which then pay for medical treatment for work-related conditions and lost wages.
Protect your business
If you are a business owner, the potential economic loss from a disability may go beyond your income. Consider a policy that covers business overhead expenses incurred while you are disabled, and key-person insurance, which protects your firm against the loss of income resulting from the disability of a key employee. For jointly owned businesses, there is a disability buy-out policy that provides funds for one partner (or the business entity) to buy a disabled partner’s share of the business.
We just scratched the surface about this important topic. Hopefully, we got you thinking about what type of insurance you may need and how much of it. If you have any questions or need help planning for disability insurance, don’t hesitate to call us!
Until Next Time!
Massi De Santis is an Austin, TX fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
