Last week we discussed the additional benefits employers offer to eligible employees. One of the benefits we did not cover is disability insurance, which is a tool that can be used to protect against the loss of income due to disability. When purchased, disability insurance provides payments to a person who is unable to work due to sickness or accidental injury. A disability may be more of a financial burden than an unexpected death, as disability results in a loss of income but no decrease in expenses (with a death one spouses’ expenses cease to exist, but with a disability both spouses are still alive and expenses can stay the same or even increase).
There are two primary types of disability insurance:
- Short-term disability insurance (STDI) provides coverage for a shorter period of time (usually up to 6 months, but it can be up to 2 years). A STDI policy may be a good option if you only need short-term coverage until your employer / other benefits kick in, or if you cannot afford a short term interruption in income (ex: if you have no emergency cash reserve).
- Long-term disability insurance (LTDI), on the other hand, provides extended coverage (often until age 65, but it depends on your unique needs). LTDI can be a good option if you already have resources to cover living expenses in the short term, but would like more comprehensive coverage in the case of a longer-term loss of income. The longer the length of benefits, the more expensive the contract will be.
Oftentimes it makes sense to use long-term and short-term policies in tandem. Because LTDI has an elimination period (explained below) that usually varies from 30-365 days, STDI can cover you through the elimination period as short-term policies normally require a shorter waiting period for the benefits to kick in.
Individuals have choices when it comes to disability insurance. They can either go through the underwriting process and pay for an individual policy or, if eligible, they can receive group coverage through their employer. Much like life insurance, many employers offer their full-time employees group short and long-term disability coverage as a benefit. While group coverage through an employer may provide you with lower premiums, an individual policy could provide you with better coverage as the policy will be individually underwritten.
Group coverage is also tied to the employer, so once the insured has separated from their company the policy may not be portable. A benefit of group coverage is that all eligible employees are covered regardless of their health. It’s possible that someone is denied an individual policy due to pre-existing medical conditions, or that policy may exclude certain pre-existing conditions.
Many people don’t realize the risk of becoming disabled, either temporarily or permanently, during their working lives. According to the CDC, 26% of adults living in the United States have some type of disability. That equates to over 61 million adults living with a disability.
Disability insurance can replace a portion of the salary you were making before you became disabled, but there are many different definitions of disability that determine when a policy will begin to pay you:
- Own Occupation: The inability to engage in your own specific occupation (this is the most expensive because it gives you the least motivation to start working again).
- Any Occupation: The inability to engage in any occupation whatsoever (this is the cheapest because it is unlikely that you will be unable to work at any job ever again).
- Modified Any Occupation: The inability to engage in any reasonable occupation that may match your education, experience, or training (a job that is close to your current occupation).
- Hybrid: There are many forms of this (ex: a policy would cover you as own occupation for the first 10 years, then switch to modified any occupation for the remainder of the policy).
There are two common methods when determining the amounts of benefits to be paid:
- Percent of Earnings: The percent of earnings method calculates the benefit by taking a percent of your earnings before disability (ex: if you are earning $10,000 per month and have a policy that pays 60%, you will receive $6,000 per month if you become disabled).
- Flat Amount: The flat amount method allows you to specify the policy payment amount, it does not need to be tied directly to earnings.
Benefits for a disability insurance policy are usually paid monthly and the insurance company normally places a ceiling on the amount of disability protection an individual can purchase. For a short term policy, the ceiling is usually 60% of your income. Long term policies can provide up to 75-80% of income replacement, but are usually set at 50-60%. These ceilings are included in order to provide some motivation for the disabled individual to return to employment and discontinue receiving benefits.
Along with the various payment options, there are some other basic provisions you should be aware of as well:
- Elimination Period: This is the amount of time you have to wait before your policy allows you to begin receiving payments. It acts as the deductible by making you cover the first portion of financial loss. The longer the elimination period, the lower the premiums will be.
- Probation Period: This is the amount of time a policy must be in force before it covers specific injuries/illnesses (used to protect insurance companies against pre-existing conditions).
Although disability insurance can be a valuable option, this is not the only way to protect against disability risk. Just like any other type of risk management matter, you can retain risk / self-insure by building savings. When evaluating the appropriateness of disability insurance make sure to consider things like your age, expected retirement date / remaining duration of work, income from other sources such as a spouse, and other savings / investments.
Derek Prusa, CFA, CFP® and Ben Webster, CFP®
Co-Founders and Owners of Aspire Wealth
