Before I define disability insurance, let’s review a story:
Joe Danger, CPA earns $100,000 a year working at a Big Four accounting firm. In his free time, Joe likes to practice juggling chainsaws. During a recent chainsaw-juggling performance at the Del Mar Fair, Joe injures his hands. Without any working digits, Joe is no longer able to use the number pad on his keyboard. He can’t work – and is not entitled to his salary!
Now that I’ve got your attention with this gruesome example, let’s define what disability insurance is and how it works – and why you need it!
As part of their employee benefits package, many employers offer some sort of disability insurance. Unfortunately, group (i.e. employer-provided) disability policies are usually far from perfect – leaving you severely exposed in the event that you’re disabled and can’t work.
Disability insurance is also referred to as income-replacement insurance – because that’s what it does. Disability insurance replaces (a portion of) your income in the event that you are no longer able to work.
To get an idea of what a disability policy may look like in action, let’s return to our fictional character: Joe Danger, CPA.
Normally, Joe earns $100,000 a year. Now no longer able to work, Joe’s employer-provided long-term disability policy pays Joe $40,000 a year, for two years.
In the story above, Joe receives a long-term disability benefit from his employer. The policy replaces a portion (40%) of his income. But, know that employers can offer two different types of disability policies:
Short-term disability policies are distinct from long-term disability policies in not only how long the benefits last, but also when you start receiving money. For example, short-term disability payments can kick in just one week after an accident or injury. Every policy is different, with the length of benefit payments varying. Consider one real-life example of an employer-provided short-term disability policy:
- coverage for 11 weeks
- at 66.7% of salary
- 7 days after the disability occurs
I’ll explain the pros and cons of this coverage shortly.
If your employer offers both short- and long-term disability policies, know that a long-term disability policy will customarily kick in after a short-term policy ceases providing benefits. You’ll likely never receive both short-term and long-term benefits at the same time. That’s because short-term and long-term benefits will rarely overlap. And, depending upon the particulars of each disability policy, there might even be a lapse in coverage between short-term disability ending and long-term disability benefits beginning.
In the example above, long-term disability benefits begin at 26 weeks. Even if you are receiving both short-term and long-term disability policies as an employer benefit, you can still find yourself with a gap in coverage. Hence, the importance of having a rainy day fund: six months of living expenses saved in cash.
Opting for Additional Long-Term Disability Coverage from Your Employer
It is not uncommon for employers to offer employees the opportunity to purchase additional long-term disability coverage. In our Joe Danger, CPA example, the base long-term disability policy provides protection of 40% of wages. This is common. Employers also sometimes offer employees the chance to purchase an additional 20% or 26 2/3% of coverage. Therefore, in the event of disability, you may be entitled to up to 66 2/3% of your wages – if you opted for additional protection.
But, should you opt for the additional protection from your employer’s LTD plan?
Own Occupation Defined
While 66% 2/3 of one’s wages is considered adequate disability insurance protection, the particular policies available through employers usually have one very large problem: an “own occupation” definition of just two years. This makes the likelihood of receiving longer term benefits dubious.
To define”own occupation,” let’s return to our hypothetical story with Joe Danger, CPA:
Joe is no longer able to perform his job as an accountant. He never purchased the additional coverage to get him to 66 2/3% of his wages. Fortunately, he is still enrolled in his employer’s base long-term disability policy at no charge. The benefit kicks in after 180 days, paying Joe 40% of his base wages. Joe collects $40,000 a year, for two years. (Joe’s base salary is $100,000.)
Two years later, the disability policy stops paying benefits.
Why do Joe’s benefits end after two years? For most group disability policies (which includes employer-provided policies), the conditions for receiving benefits usually change at the two-year mark:
- Before two years, “disability” means you cannot perform YOUR OWN job (for Joe, this means being an accountant)
- After two years, “disability” means you cannot perform any job
Two years later, Joe still cannot perform his job as an accountant. BUT, Joe could find work as a door greeter at Walmart. On that basis, (i.e. you do not need working hands to do the job of a door greeter), the disability insurance policy will stop paying benefits after two years. For Joe, or anyone holding just the employer-provided disability policy (and not a better, private policy), this is a big problem.
Were you to take only the long-term disability coverage offered by your employer, you could have serious gaps in income protection. The graphic below shows how one employer’s disability insurance offering starts and stops benefits over time – subjecting a disabled employee to massive losses in income.
Fortunately, you can supplement your employer-provided policy with a private disability policy, and a rainy day fund. Doing so will give you better protection. The below graphic (relative to the graphic above) shows how a well-funded rainy day fund and a private disability policy can fill the void left by insurance coverages.
Filling the Gap Left by Employer-Provided Disability Insurance
The disability insurance policies can be a nice employee perk. Unfortunately, they do not fully address the needs of income replacement in the event of disability. Fortunately, a little financial planning provides a solution to the gaps left by employer-provided disability policies.
PROBLEM #1: The short-term disability insurance policy (or the absence of any short-term policy) can leave gaps in coverage of more than three months.
PROBLEM #2: An employer-provided long-term disability policy may provide a base amount of coverage (such as 40%) and changes the meaning of “disability” after two years of benefits.
SOLUTION: Purchase a private long-term disability with the following features:
- An “own occupation” definition that does not change
- A cost-of-living adjustment (so that benefits grow with inflation)
- A partial disability provision (so you can work part-time and still receive benefits)
- Benefit coverage to age 65
- Noncancellable contract
You can shop for a disability insurance policy at Policy Genius. Be sure to purchase a long-term disability policy from a well-rated insurance company. You can look up ratings at AM Best. Insurance industry veteran Craig Applefield suggests avoiding any insurance company with a credit rating below “A.” Fortunately, policies with higher ratings also usually offer lower premiums, notes Applefield.
When working with an insurance agent to purchase a disability policy, make sure that the agent has understood exactly what you want from a disability policy. Then, carefully review the policy proposals sent your way.
Remember, an insurance agent is not a fiduciary. They do not have your best interest in mind. Their only goal is to sell the most expensive policy, so they can earn the highest sales commission. It is your responsibility to review the policy to make sure that you are getting exactly what you need – nothing more or less. Of course, if reviewing insurance contracts isn’t your cup of tea, you can work with a fee-only fiduciary to review any disability contract proposals for you.