If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan. Stop by the orientation class HERE first for class orientation/overviews and HERE for more information about the website.
Class Objectives: To understand the fundamentals of disability insurance and how to calculate your short and long-term disability potential needs.
Prerequisites: PF104: Creating a Budget and Cash Flow Statement (you will need to know your monthly budgeted expenses for this class!)
Handout: Current Disability Insurance Coverage
Assignment: Disability insurance needs calculation in Excel| Google Docs (previews in lecture material)
CLASS LECTURE
When you’re dealing with putting various types of insurance in place, you are having to seriously consider the impact of some very undesirable future circumstances that you may have to face. Disability is such a possibility and obtaining disability insurance is just as vital as obtaining life insurance. We’ve reiterated many times the purpose of insurance in general: the purpose of insurance is to shift the risk of possibility of future financial loss from yourself to an entity (insurance company). This is possible by exchanging payment of premiums with the promise by the insurance company that they will cover specific situations that could otherwise cause you to lose a significant investment of cash or assets, or in this situation the loss of income that may result from a disability.
When a family’s breadwinner dies, life insurance covers a lump-sum benefit that can pay for both the up-front funeral and burial costs and ongoing expenses of dependents. Unfortunately when a family’s breadwinner becomes disabled severely enough to lose their ability to provide an income, not only is there a need for insurance to replace income, but often to cover even more expenses such as medical bills, medical insurance when no longer provided as an employee benefit, a caretaker if the other spouse needs to work, modifications to living spaces, etc. From a financial perspective, disability over a long-term period can be much worse financially than a death. Certainly, there is also a greater risk of becoming disabled than there is of death.
Disability insurance is a vital part of every financial plan and we’ll cover 3 types of disability insurance:
- Short-term disability insurance
- Long-term disability insurance
- Social security disability insurance benefits
Worker’s compensation is also a type of disability insurance, but it will not be covered in this class.
MY EXPERIENCE WITH THIS INSURANCE
Well friends, I’m not going to lie to you – I thought I had a good idea of what our current disability insurance coverage was through my husband’s employer but it turns out I was way off. Fortunately, he had even better coverage than I thought, but I was surprised that I had no idea.
In addition, both my husband and I (if/when I start working again), would be eligible for disability benefits through the government Social Security program.
WHAT DOES THIS INSURANCE COVER?
Both short-term and long-term disability insurance generally cover up to 60% of your pre-disability income. The percentages range anywhere from 40-70%, but no disability insurance covers 100% of income.
Short-term disability policies generally start within 14 days and last for few weeks up to a few months (generally less than 6 months) that you are unable to work.
Long-term disability policies start paying at some period after short-term coverage is up (generally starting around 90-180 days) and can last much longer than short-term disability from years up to your entire life depending on benefits purchased.
Most disabilities are caused by illness, with a smaller portion being caused by accidents. Some examples of the most common long-term disability claims include:
- Musculoskeletal/connective issues (such as arthritis, back pain, spine/joint disorders, etc.)
- Cancer
- Cardiovascular/circulatory conditions (such as heart attacks, heart disease, etc.)
- Injuries (such as broken bones, burns, poisoning, etc.)
- Mental disorders
You should look through your current (or prospective) long-term disability policies to make sure you know exactly what they will cover, as it may differ from policy to policy.
There is a distinction between “partial” and “total” disability for insurance purposes. A partial disability would not prohibit you from completely working in contrast to a total disability, which would prohibit you from working entirely. Disability insurance generally covers total disability only, but partial disability can be covered under riders to the insurance policies and typically cover 50% of the benefit under total disability policies.
A significant thing to look for in your disability policy is that it should have “own occupation” coverage instead of “any occupation” coverage. Any occupation coverage means that you must be too disabled to hold down ANY job they are reasonably suited for, even if wages are substantially lower, which may result in being denied benefits unless you are very severely disabled. However, even most “own occupation” policies pay only 24-36 months under that definition and then change to “any occupation” policies after that time. Also make sure that the policy is non-cancelable.
Part of the government’s social security program includes disability benefits. If you haven’t obtained your benefit statement, you should do so now at the Social Security website. Your statement will tell you exactly what benefits you qualify for, as the amount you receive depends on your past wages. To qualify for social security disability benefits, there are much stringer requirements and a longer waiting period as compared to long-term disability policies, so do not depend on these benefits to replace long-term disability insurance. The requirements for social security disability insurance (SSDI) include:
- Have a medical condition and be under the care of a physician
- Have a disability that is expected to last for at least a year, or have a terminal illness
- Be totally disabled (no partial benefits are allowed)
- Be unable to do your past work and be unable to adjust to other work because of your medical condition
- Not make an average of $1,130 per month in income
Social security benefits can take up to 2 years to be approved and for the benefits to start, depending on how serious the disability is and how easy it is to prove your inability to work.
HOW MUCH OF THIS INSURANCE DO I NEED?
It will be incredibly helpful for you if you have both an emergency fund and 3-6 months living expenses in cash reserves. This way, you’ll be able to reduce disability premiums by being able to have a longer time on your insurance policy before benefits kick in. In addition, you will only need long-term and not short-term disability insurance if you have short-term savings.
Short-term disability policies are only offered under employer group policies, so you will have little choice about how much insurance you “need.”
Your long-term disability insurance needs are based on the following:
- Sickness and short-term benefits provided by your employer that allow you to keep your savings for long-term expenses.
- The availability and amount of government provided Social Security Disability benefits for which you qualify.
- How much of your income you need to replace to meet your ongoing expenses (for example, if you only live off a small portion of your income, you’ll be able to get by with less insurance coverage but if you have a high mortgage, auto payments and other large bills, you may need to purchase the maximum coverage that you can).
- How long you can wait before your benefits kick in based on your current savings available to pay for on-going expenses in the event of a severe disability.
- How long you desire to cover a disability (for a few years, until retirement age, or even for life).
Although 60% (the average coverage provided by long-term disability policies) seems like a low amount to replace your income, it should be noted that if you pay for your long-term disability insurance premiums personally with after-tax dollars the benefit amounts you received are not taxable. If your employer pays the premium and doesn’t include the cost in your gross income, unfortunately these benefits will be taxable for you. If premiums are split between you and your employer, the taxability of benefits will be prorated. In addition, some of your expenses will likely go down during this period, such as transportation costs, clothing and eating out.
The amount of long-term disability insurance you need to purchase will also depend on your eligibility to receive government social security benefits, which are not taxable unless your total income exceeds the base amount set by the IRS ($25,000 for single filers and $32,000 for married filing joint filers). To check your possible benefits, go to Social Security Online. It should be noted again that Social Security disability benefits have stricter requirements for disabilities and take longer for benefits to kick in. In addition, some disability policies reduce their benefits by amounts received from Social Security Disability Insurance.
To calculate your disability insurance needs, I’ve got a spreadsheet for you use to fill out your current and desired disability coverage. In this calculation, you should use a worst case scenario that you will have a total disability that completely prevents you from being able to work. You can then go back and run different scenarios including one with a partial disability assumption if your long-term disability insurance covers it and also under assumptions of different lengths of time of being disabled. In addition, the spreadsheet only includes 10 years, but you can expand the years as you’d like to analyze more (or less) years.
- First, enter your personal financial information including monthly salary/wages, other income from a spouse’s employment or investment income, and the average monthly expenses you need to cover each month. Then enter the cash reserves you have available to cover your expenses during a disability situation and all of the information from your current short-term and long-term disability policies as well as the government social security disability benefits from your social security statement.
- To start your analysis, you should first take into consideration any sick-leave plan in place by your employer. These generally start with the first day of sickness and are very short-term in nature (for example, 10 days). Many employers have combined their sick-leave plans with paid-time off, vacation and holiday time, so you’ll have to analyze your personal financial situation.
- Next, consider any short-term disability insurance (STD) that you have. If you don’t have short-term disability, consider whether you have sufficient savings to cover the income loss before other benefits kick in.
- Third, consider long-term disability insurance (LTD) benefits, when they start to pay out and for how long they will pay benefits. Consider Social Security disability benefits (SSDI) during this time frame as well, although keep in mind they will have stricter requirements to qualify. Be sure to look at your long-term policy and determine whether they will pay in addition to SSDI or if your insurance benefits will be reduced by the amounts paid from SSDI.
- Cover any gaps with additional insurance or save additional amounts to make sure you’re covered.
HOW MUCH DOES IT COST?
Generally, the cost of long-term disability insurance will be approximately 1-3% of your salary, with females costing more than males due to their higher rate of using benefits. However, part of this cost is generally paid as an employer benefit if you are not self-employed. The cost of disability insurance will be impacted by the following factors:
- Age and gender
- Occupation
- Current health
- Length of coverage period desired
- Salary replacement percentage desired
- Additional benefit options such as own occupation policies and benefits not being reduced by SSDI
By getting a non-cancelable long-term disability insurance policy, you will be able to lock in your premium rates so that they don’t go up as you get older. As long as you’re paying your premiums, you will be covered.
WHERE DO I OBTAIN COVERAGE?
Most people obtain disability insurance through their employer. In fact, short-term disability policies are only available through employers. There is always a length of service at the company before these benefits kick in, for example 6 months of employment.
In addition, long-term disability policies can be purchased through:
- Employer group plans
- Independent local insurance agents
- Directly from insurance companies online, such as Aflac, Allstate, State Farm, MetLife, etc.
Be sure to do your research about the specifics of each policy, especially with regards to waiting periods, length of benefits and exclusions. Only use insurance companies that are top rated.
HOW DO I MAKE A CLAIM?
To make a claim under short-term and long-term disability insurance, you should notify the insurance company as soon as possible after the accident or onset of the illness. A proof of loss must be filed that includes an explanation of the disability by the insured person, a physician’s statement and a statement by the employer (if applicable). There is also a requirement to submit periodic physician’s reports.
SUMMARY
Disability insurance plays a vital role in your personal financial plan and is just as essential in protecting your assets and families as life insurance. By analyzing the financial impact that a disability will have, you can make sure that you have or obtain sufficient coverage.
EXAMPLE: THE SMITH FAMILY
Mary Smith is not eligible for either short-term or long-term disability coverage through her employer because she works part-time. Jim Smith has short-term and long-term disability coverage through his employer. Both are provided fully by his employer and not included as part of his compensation (which is great, but also means that if he uses these benefits, he will have to pay tax on them).
His short-term disability benefits have the following terms:
- Eligibility for coverage begins at 6 months of continuous employment
- Income replacement: 60% of employee’s regular salary up to a maximum of $10,000/month, in the case of commission based employees a monthly average of the preceding 12 months will be used
- Waiting period: 14 days
- Benefit period: 13 weeks (90 days)
His long-term disability benefits have the following terms:
- Income replacement: 60% of employee’s regular salary up to a maximum of $10,000/month, in the case of commission based employees a monthly average of the preceding 12 months will be used
- Benefits are reduced by any amount received from Social Security Disability Insurance (SSDI)
- Waiting period: 180 days
- Benefit period: up to age 65 if disabled before age 62 (there are additional benefit periods for older workers)
- During the first 24 months, this is an own occupation policy (unable to perform the responsibilities of your current job). After 24 months, it converts to an any occupation policy (unable to perform job duties of work consistent with your education and training).
Their disability spreadsheet calculations show some gap in coverage, most notably between the 5th-6th month of disability between short-term and long-term coverage. In addition, there is an ongoing monthly gap of $452.
Jim should look into getting supplemental long-term disability coverage that does not reduce benefits by social security disability benefits, which would fix the $452 monthly shortage after the 2nd year and provide additional money for his disability care and medical bills. Also, he should consider a policy that has an own occupation benefit, rather than his current one that converts to an any occupation policy. This may have changed the previous calculation in a significant way if he had a disability that was not so severe as to allow him to work in a different industry, possibly with reduced salary. In addition, he should build up his cash reserve so that it covers the gap between the 5th-6th month before long-term disability benefits begin.
HOMEWORK ASSIGNMENT
If you aren’t sure whether you have sufficient disability insurance, you should do some calculations to make sure that both you and your dependents will be well-cared for under any circumstances.
- IMPROVING– At a minimum, make sure that you have 3-6 months in saving and check your social security disability benefits.
- INVESTED– Calculate your disability insurance needs and make sure that you are covered for at least 10 years between cash savings, short-term disability and long-term disability. Consider whether you should contact insurance companies now or wait until open enrollment to adjust your benefits.
- UNSTOPPABLE– Calculate your disability insurance needs and make sure that you have 3-6 months in savings and long-term disability coverage that will last as long as you may need it. Get quotes from several different insurance agencies and compare coverage.
Make sure you keep a copy of your calculation saved as an excel file and also in your Financial Plan binder under the Tab Insurance-Disability. You should analyze your insurance needs periodically throughout the future as your needs change.
HANDOUT
Here is a handout you can use to summarize your disability insurance coverage, including all the information you need to gather to analyze your coverage in the spreadsheet above.
