Protecting Your Most Valuable Asset with Long-Term Disability Income Insurance
If I were to ask you to name the most monetarily valuable asset that you have, chances are I’d get responses such as “my home” or “my investment portfolio” or “my car.” While all of these could be considered an asset for you (cars generally less so), the reality is that if you are in your 20s, 30s, or 40s and still in the midst of your working years, your greatest asset is your ability to continue to earn a living in your profession. Home ownership is a great thing, but without an ongoing income how are you going to pay your mortgage? Saving and investing are things that Americans need to be doing more of, but most young professionals do not yet have enough saved in their portfolios to sustain themselves long-term. Simply put, for the young professional, your ability to continue to work in your profession IS your most valuable asset and is worth protecting from a potential long-term disability. How do you do that? You do that with Long-Term Disability Income Insurance.
Misconceptions about Long-Term Disabilities
When people hear the term long-term disability, they generally think of someone who has suffered an injury that will leave them disabled for the rest of their life, such as a traumatic brain or spine injury. While, there are certainly instances where this occurs, the average long-term disability duration is 34.6 months according to the Council for Disability Awareness with the top three reasons leading to long-term disability claims being Musculoskeletal disorders (29%), Cancer (15%), and Pregnancy (9.4%). While most people feel like disabilities won’t happen to them and won’t keep them from working, the fact is that, according to the Social Security Administration, about one in four 20 year olds today will be unable to work for at least a year at some point during their career due to a long-term disability.
Even though the disability may not be permanent, the effects of a long-term disability event can be financially debilitating and can burn through years of savings very quickly. Let’s say that Beth has been consistently saving 10% of her income each year for the past ten years. In year 11, she has a bout with cancer that keeps her out of the workplace for a year. If Beth has no disability insurance to supplement her income over that period, ignoring any growth that might have happened in the account over the time period, she will effectively spend through ten years’ worth of savings in a year’s time! Should the cancer battle go on closer to the 34 month average, she could be looking at a home foreclosure or personal bankruptcy.
An Overview of Long-Term Disability Income Insurance
Where short-term disability income policies are designed to provide short term supplemental income for an individual with a disability, LTD policies, as the name implies, are designed to provide supplemental income over the long term. As with any insurance policy, these policies are contracts made between the individual insurance company and the insured that outlines the benefits provided in the event of a claim. While some types of insurance policies, such as term life insurance, are fairly straightforward in nature, disability income insurance policies tend to be much more complicated contracts and vary wildly from company to company. With LTD policies, the details of the individual contracts and the way they are written matter A LOT. Seemingly similar contracts could end up providing substantially different benefits to the insured, based on the addition (or omission) of a few words.
For example, the answer to the following questions are all spelled out in the language of each individual contract and the answers vary wildly:
What is the definition of disability (you can’t perform your job? any job? If you are disabled, are you fully disabled or partially disabled? etc.)?
When do benefits begin and when do they end?
How much is the benefit that you will receive if fully disabled? How much will you receive if partially disabled?
If disabled, are you allowed to work in a different occupation that you can do and still receive your disability benefit?
Is the premium the same each year or does it increase in cost over time?
Can the insurer alter the terms of the contract (premiums, benefits paid, etc.) or cancel your coverage altogether?
Does the policy coordinate benefits with what you’re getting from Social Security or is it in addition to what you get from Social Security?
If I go on claim, will the monthly benefit rise with inflation or does it stay the same?
Is my preexisting condition covered or excluded in the policy?
Can I increase my benefit coverage somewhere down the road without proof of insurability?
If I leave my current job, is my disability coverage portable (i.e. can I take it with me?)?
How does the contract treat nervous/mental disabilities?
Needless to say, there are a lot of moving parts with these policies and it can get fairly complicated. Before you look to purchase a policy, I would suggest doing your homework on the product and educate yourself on which type of policy is right for you. While it’s hard to cover all of the ins and outs of these policies in a single post, the remainder of this article will be dedicated to educating you on the key terms of these policies and the main points to consider when selecting an LTD policy that’s right for you.
Key Terms to Understand
Definition of Disability (Own Occupation, Modified Own Occupation, and Any Occupation)
The definition of disability, as the name implies, defines what constitutes a disability in an LTD contract. This is probably the single most important part of a disability policy and should be examined thoroughly when making a decision on coverage. There are three main definitions of disability: Own Occupation, Modified Own Occupation, and Any Occupation.
Own Occupation Definition of Disability – In a policy that has an own occupation definition of disability, you are considered totally disabled if you are unable to perform the primary duties of your particular occupation. Regardless if you go into another occupation or not, you are considered totally disabled as long as you are no longer able to work in the occupation for which you were insured. Because of this, own occupation is considered the most flexible definition of disability.
Modified Own Occupation Definition of Disability – Modified own occupation is similar to an own occupation definition of disability with one important difference: the insured is not allowed to be gainfully employed in another occupation while collecting LTD benefits. The idea behind this definition of disability is to prevent the insured from double dipping: collecting disability for one occupation, while also getting paid for another occupation. This definition of disability is usually a little bit cheaper than a true own occupation definition of disability, but also does not provide quite as much flexibility.
Any Occupation Definition of Disability – An any occupation definition of disability essentially states that you must be unable to perform any type of occupation to be considered totally disabled. For example, a surgeon may no longer be able to perform surgery, but if he can bartend or greet at Wal-Mart, then he has not met the any occupation definition of disability as he can still perform some occupation. This is considered the most restrictive definition of disability and is generally not recommended for highly specialized professionals, such as doctors or engineers.
Elimination Period
In order to keep the costs of the policies lower, all LTD policies have some sort of “elimination period” that requires the insured to either self-fund or utilize their short-term disability policy to supplement their income for the first few months of a disability before the policy begins to pay out. Think of this as the LTD version of a deductible, except instead of it being based on an out of pocket dollar amount, it’s based on days disabled before the policy begins to pay a benefit. Elimination periods can vary anywhere from 30-365 days, but the most common elimination periods are 90, 180, and 365 days. Generally, the longer the elimination period is, the less expensive the policy will be.
Benefit Period
The maximum agreed upon period of time that the insurer will pay on a disability claim. Benefit periods can range anywhere from two years to providing income all the way out until age 65, 67, or 70. Generally, the longer the benefit period is, the more expensive the coverage will be.
Occupation Class
Insurance companies assign a risk-based class rating to all occupations based on the expected riskiness of a given occupation. An occupation that is associated with more disabilities will be grouped into an occupation class with other risky occupations, while an occupation with very few disabilities in that field will be grouped together in a less risky class rating with other occupations of similar risk. Professionals in risky fields can expect to pay more for the cost of disability insurance than other professionals of similar health in less risky occupations. For instance, pathologists and engineers generally have very favorable occupation ratings, thus the cost of LTD is relatively cheap. Chiropractors, on the other hand, have a harder time getting LTD coverage and if they do get it they pay a lot more because the profession has a higher chance of debilitating skeletal injuries related to the physical nature of working on patients.
Non-Cancelable and Guaranteed Renewable vs Guaranteed Renewable
Non-Cancelable and Guaranteed Renewable – With a non-cancelable and guaranteed renewable policy, as long as the insured stays up to date on his/her payments, the insurance company cannot change the premium or terms of the policy.
Guaranteed Renewable – With a guaranteed renewable policy, as long as the insured stays up to date on his/her payments, the terms of the policy can never be changed, BUT the insurer CAN change the premium of the policy. While it is fairly rare for a carrier to change premiums, it does happen on occasion. Should a carrier increase rates, they must do it for an entire class of people, not just one individual person.
Cost of Living Adjustments (COLA)
Disability policies provide an optional benefit that allows the benefit to increase with inflation. If you are on a disability claim for a substantial period of time, inflation can begin to eat away at the purchasing power of the benefit that you are receiving. A COLA rider prevents this from happening. Please note that cost of living adjustments only begin once on claim, not before.
Automatic Increase Option
While the COLA rider allows for your benefit to keep up with inflation when disabled, the automatic increase option helps to keep the amount of coverage you have up to speed with inflation if you’re not disabled.
Future Increase Option
The Future Increase Option is an optional rider that allows individuals to lock-in the ability to purchase a pre-set amount of additional coverage somewhere down the road without proof of insurability. This is quite valuable for people who expect their incomes to increase substantially sometime in the future, such as medical school residents.
Level Premium Policies vs Annually Renewable Policies
There are two main ways that insurance companies structure LTD policy premiums: level premium policies and annually renewable policies. An annually renewable policy’s premium increases every year as you get older. These policies are less expensive in the early years of the policy and get more expensive in later years. Level premium policies, on the other hand, has a premium that remains the same from year to year for the lifetime of the policy (barring a rate increase in a guaranteed renewable policy). What this means is that in the early years the annually renewable policy will be less expensive than the level premium policy but will get substantially more expensive than the level premium policy over time. For the average person, the level premium policy will generally save you money over time if you plan on keeping the policy until you’re 55 or 60, however if you feel like you will be in a position to self-insure (i.e. if disabled, you can sustain yourself out of your investment portfolio) by the time you’re 40 or 45 than the annually renewable might be the better way to go.
Key Things to Know When Buying a Long-Term Disability Policy
1.)Whether an LTD Benefit is taxable or not is Dependent on Who Pays for the Insurance
Whether the benefit on an LTD is taxable or not to the insured is dependent on who pays the premiums on the policy and if they were paid with pre-tax dollars or after tax-dollars. If an employer is offering a group LTD policy to its employees as a free benefit and is paying the cost of the insurance in pre-tax dollars, then in the event of a disability the benefit will be taxable to the employee. If you, the insured, were to go out into the private market and purchase your own disability policy with after-tax money, then the benefit would not be taxable.
If the employer were to offer subsidized group disability coverage (i.e. the employer pays part of the premium and you pay part of the premium), then the benefit would be split proportionally based on who paid how much of the premium. For instance, let’s say that the group LTD policy you have through work pays $3000 a month in benefits. You paid half of the premium with after-tax dollars and your employer paid the other half with pre-tax dollars, then half of the monthly benefit ($1,500) would be taxable to you and the other half of the monthly benefit ($1,500) would not be taxable.
2.) There are many areas in life where being cheap is a good thing, but LTD Insurance is not one of them
There was a commercial a year or two ago that stated “Being cheap is good and sushi is good, but cheap sushi is never good.” I feel like you could replace sushi in that sentence with LTD insurance and it would probably be equally as true (though I probably wouldn’t go so far as to say “never good” because someone sometime probably got some decent LTD coverage for cheap). While you don't want to overspend on disability coverage that you don't need, you certainly don't want to cut corners and under spend on coverage that you and your family really do need. For instance, it might be really tempting to purchase a policy with an any occupation definition of disability in order to save some money and not have to spend the additional premiums for an own occupation or modified own occupation definition of disability, but I would highly encourage you to not give in to that temptation. Like the cheap sushi, chances are you will regret that decision! If you are a highly specialized professional, such as a doctor, lawyer, or engineer, make sure you pay the extra money for the own occupation or modified own occupation policy.
As this article has hopefully shown, long-term disability income insurance is not a commodity where each policy is effectively the same thing. There can be substantial differences from policy to policy and carrier to carrier. Instead of just going with the cheapest policy you can find, make sure that you find the right policy for you that gives you proper coverage where you and your family will be okay if something unforeseen should happen.
3.)Having Group LTD through work does not necessarily mean that you are adequately protected from a disability
Over the years, I've had several people tell me that they're all set on the LTD side of things because their employer offers them group disability coverage through work.While many employers offer some group LTD coverage as a free benefit and coverage is generally a little easier to get approved for through work, there are several fairly big shortfalls that you regularly see with most Group LTD plans. The main shortfalls of these plans are as folllows:
Most policies utilize an any occupation definition of disability.
The benefit is taxable if paid by employer.
Benefits many times are capped. There is usually a monthly maximum dollar amount that a group LTD policy will pay out to any employee under the plan. For instance, the policy could say that it pays 60% of your gross income in the form of a monthly benefit, but it also has a cap of $1,000 a month. If you're making $100,000 a year, you're not going to get 60% of your monthly income, rather your benefit is going to be capped at $1,000 a month.
Benefits will generally offset with what you get from Social Security.
Many group LTD policies are not portable. This means that if you should leave your employer at a future date, then you cannot take the coverage with you. If your health has deteriorated between now and then, you may not be able to get coverage at that point.
For all of the reasons listed above, when purchasing LTD coverage in excess of whatever the free benefit might be from the employer, I generally encourage clients to try to get a supplemental personal LTD policy directly with an insurer, instead of getting additional group coverage through work.
4.) Purchase LTD while you’re young and healthy
Chances are, you’re probably not going to get any healthier than you are right now. Get your LTD coverage in place while you’re still healthy and insurable. It doesn’t need to be a life-threatening illness to get you declined for coverage. Old football injuries, bad backs and joints, bouts with cancer, and complications from a pregnancy all can make it much more difficult for you to get LTD insurance in place somewhere down the road (at least without having certain pre-existing conditions being withheld from coverage). Get the appropriate amount of coverage in place now while you're young and healthy.
5.) Buy a policy with a pool of additional benefit coverage to ensure future insurability
If you are a medical resident, petroleum engineer, or some other highly specialized professional that expects to see their income rise rapidly in the future, I’d highly encourage you to utilize a Future Increase Option rider when buying a LTD policy. This will lock-in the ability for you to increase your coverage in the future without having to prove insurability.
6.) Don’t Drag Your Feet on Getting Coverage in Place
Long-term disability insurance isn’t the most exciting thing to talk about, but it is extremely important. Don’t drag your feet on getting coverage in place or convince yourself that you don’t need it. None of us know what the future holds, and if something unexpected should happen, I can assure you that you’ll be thankful for having the correct coverage in place.
Conclusion
Long-term disability income insurance is an often overlooked, but incredibly important part of your insurance coverage. Make sure that you and your family are adequately protected from loss of income due to a disability.
If you want to have a more detailed discussion on what type of long-term disability income policy is the right fit for you or have any other questions, feel free to email me at daniel@sweetgrassfp.com or schedule a free introductory consultation.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
