Simple Money: A No-Nonsense Guide to Personal Finance - Tim Maurer (2016)

Part IV. PLANNING FOR THE UNEXPECTED

Chapter 16. DISABILITY INCOME: Protecting Your Assets

WHY do I need to read this chapter?

You’ve got a machine sitting in the garage. It’s a money-printing machine, and it’s perfectly legal. This machine is expected to print $75,000 this year, before taxes. You’ll use the net cash to pay your household expenses.

Each year, the machine will print 3 percent more than it did in the previous year, and it will continue doing so for the next 40. That means, over its lifetime, the machine will print $5,655,094.48,1 easily making it your most valuable asset today. Yet it sits in your garage, between an inherited set of golf clubs and a wheelbarrow with a flat tire, unprotected. Uninsured.

The machine, of course, is you, or more specifically, your ability to generate an income. And it didn’t come cheap. You and your parents invested years of training and likely tens of thousands of dollars in hopes that your machine would not only support you financially for a lifetime but launch another generation as well.

We don’t question the need to buy insurance for the things our money machine purchases. But few know if—or at least how, and to what degree—their income generation engine is protected.

Do you?

You will by the end of this chapter.

Do You Really Need It?

The insurance product that helps protect your income in the case of a disabling injury is disability income insurance. Although, according to Carol Harnett, the president of the Council for Disability Awareness, it should be called “income protection insurance” because the focus on disability draws attention away from what is really being protected—your money-printing machine.

If you work for a medium- to large-sized company, you likely have a group disability income insurance policy as part of your benefits package. Indeed, you might have two—a short-term policy and long-term disability (LTD) coverage. But please don’t stop reading here if you fall into that category. Unfortunately, you can’t assume your group coverage is sufficient. Indeed, most group coverage isn’t.

A short-term policy is helpful but isn’t necessarily required to protect you from the risk it’s designed to mitigate if you have saved adequate emergency cash reserves. The long-term policy, however, is the one on which we’ll focus, because it deals with the far larger risk exposure.

Moving Parts

Disability income insurance policies contain a maddening number of moving parts. Here is a not-so-comprehensive list of provisions that can vary from policy to policy, but that you’ll want to understand:

· Base benefit—This is the amount of income you’d receive monthly in the case of a qualifying disabling injury. Most policies (although not all) won’t pledge a base benefit higher than 60 percent of your pre-disability income (after tax), lest policyholders become incentivized to conjure imagined disabilities.

· Benefit period—This is the maximum length of time for which your disability income insurance policy will pay benefits. A “lifetime” benefit typically extends only to age 65 or 67, the presumed retirement age.

· Residual benefit—This policy feature allows you to receive a portion of your benefit if you’re capable of generating a portion of your income. Without the residual benefit, it may be an either/or proposition.

· Elimination period—This is the period beyond which your income-limiting disability must extend before you’ll begin to receive a benefit (typically 30 to 90 days). The further you extend the elimination period, the lower your premium will be.

· COLA—Yes, there is a cost of living adjustment intended to help your LTD benefit keep pace with inflation, but for most policies, it kicks in only after the inception of your disability.

· Future insurability options—FIO enables you to purchase additional chunks of LTD coverage in the future. It’s really the second half of what most of us would expect from a COLA provision. While this makes a ton of sense for insurance actuaries, it understandably feels like a “gotcha” for many consumers.

· Renewability provision—Another item that seems possible only in the land of insurance, renewability provisions stipulate whether or not, and to what degree, your insurance company could alter or cancel your coverage in the future.

· Social Security offset—There is a Social Security disability benefit, but it is notoriously difficult to qualify for. An offset provision will reduce your LTD insurance benefits by the amount of any Social Security disability benefit you happen to receive. Accepting the Social Security offset could reduce your premium without increasing your risk.

(Not) Flipping Burgers

Arguably, the most important provision in your LTD policy is the definition of the word disability. The primary distinction is whether your policy covers “own-occupation” or “any-occupation” disabilities.

An any-occupation policy requires that you be unable to perform the material duties of any occupation to receive your LTD benefit. Emphasis on any. With no offense intended to the lovely greeters at Walmart or the burger flippers of the world, we must acknowledge that the requisite skill required to perform the material duties of those jobs is quite limited. As is the pay.

Indeed, the whole point of disability income insurance is to help replace a portion of your income, not someone else’s. Enter own-occupation coverage, and similar variants such as “modified own-occupation” and “income replacement.” If you’re disabled enough that you can’t do your job, you’re covered. That’s the plan.

The only problem is that most group (employer) LTD policies are very limited in their application of the hair-splitting definition for what constitutes a disability. The vast majority of them read something like this:

Own-occupation for the first two years; any occupation to age 65.

This means that you’re reasonably well covered for the first two years, but then, unless you’ve suffered a very serious disabling injury or illness, you’re likely to lose your coverage. And even if you’re still within the first two years, please note that you’re likely not optimally covered for yet another drawback common among group policies—tax treatment.

Here’s the problem. I mentioned earlier that the highest LTD benefit you’re likely to receive from an insurance company is around 60 percent of your pre-disability income—after-tax. While 60 percent after-tax is still likely to be less than you received in your paycheck before your disability, especially when considering the likelihood of increased medical expenses during this time, it should hopefully be enough to float your household. And if you’re paying for a private LTD policy with after-tax money, the benefit would be tax free. However, here comes the big “but.”

If your company is deducting their payment of your group LTD premiums as a business expense—and most are—the benefit to you would be taxable. Yes, the IRS allows a tax break on only one end of this equation. This means your 60 percent disability income insurance benefit would really equate to more like 40 percent after tax, an amount that would almost surely result in a financial hardship for the majority of households.

These aren’t the only limitations with most group policies. “Group LTD coverage generally ends when employment ends,” says Zack Pace, senior vice president of benefits consulting at CBIZ Inc. Group policies generally aren’t portable. And other common limitations, according to Pace, are exclusions for preexisting conditions, maximum monthly benefit caps (a big one for high-income earners), and no cost of living increase (which is especially limiting for younger workers).

What to do, then?

The Simple Money LTDi Guide

If you are one of the majority who has a watered-down group LTD plan and nothing else, consider the following plan of action:

1. Analyze your group plan, specifically the any/own occupation definitions and the benefit taxability.

2. Lobby your human resources department by suggesting the benefits of enhancing those provisions.

3. Retain a supplemental, private LTD policy through a reputable carrier with the following provisions and/or riders:

a. Base benefit up to at least 60 percent of after-tax income. Higher, if available.

b. Benefit period to age 65 would be great, but at least five years.

c. Residual benefit, to ensure you can get a partial benefit if you work part-time.

d. Elimination period of 90 days, or even 120 days if you can afford it.

e. COLA so that your benefit will rise annually in the case of an extended disability.

f. Future insurability option so that you can increase your base benefit with rising income (if this isn’t included in the policy).

g. Renewability provision to ensure you’ll continue to be insured. Noncancellable/guaranteed-renewable is ideal.

h. Social Security offset may complicate claims, but it will help save on premiums.

i. Disability definitions might be the most important feature. “Any-occupation” is too weak, but pure “own-occupation” can be cost prohibitive. Consider “modified own-occupation,” “income replacement,” or the equivalent.

It’s vital that you shop among only solid insurance carriers. “Carrier financial strength, ratings, and reputation” are some of the most important LTD policy considerations, according to Todd Grandy, a disability income specialist at Northwestern Mutual.

Disability Planning for the Self-Employed

We’ve spent the bulk of our time discussing how to enhance or supplement your disability income insurance if you’re one of the majority of people who has a group disability income insurance policy through work. What if you’re not? What if you work for a small company that doesn’t offer LTD coverage at all, or you’re self-employed?

Well, do you want the good news or the bad news first?

Okay, the bad. If you don’t have any group coverage, you’re going to have to spring for a long-term disability income insurance policy yourself. This is bad news because it’s not particularly cheap. It is likely that covering up to 60 percent of your pretax income is decidedly more expensive than adequate life insurance, for example. But that’s for good reason. Your chances of being disabled in your working years are significantly higher than your chances of dying—before age 65, anyway.

What could possibly be the good news, then? Well, if you’re personalizing your policy instead of merely accepting what you get from your employer, you’ll likely have much better coverage if you incorporate the provisions included in the Simple Money LTDi Guide.

If you are buying your own policy, however, it’s important to remember what we discussed about taxes. Yes, if you’re self-employed, you could deduct the premiums as a business expense, but that would require subjecting any benefits received to tax. Don’t do it. Bite the bullet and pay your premiums (a smaller number) after-tax so that your benefits (a bigger number) will be tax free if needed.

Wheelchairs and Crutches

What’s the first image that comes to mind when you read the word “disability”? For most, it’s a wheelchair or something else that connotes a serious lack of physical functionality. But most disabling injuries aren’t visible and only partially impair their victim’s capabilities. Unfortunately, a partial disability can have a devastating impact on a household’s finances as expenses, often medical, rise while income falls.

Although it’s confusing, misunderstood, oversold, and underappreciated, long-term disability income insurance is for most income earners simply “the cost of doing business.” Especially if you’re in your thirties or forties and your future income is your largest asset. After all, you’ve got to protect that money-printing machine.

1. Your ability to produce an income is likely your biggest asset. It’s like a money-printing machine. Properly insure that machine with disability income insurance.

2. Disability income insurance contains a maddening number of moving parts. Know which you need to pay attention to and which you can ignore.

3. The Simple Money LTDi Guide involves taking advantage of the best that your group policy at work has to offer and then getting a solid supplemental policy.

4. We tend to view disability as a total disability, and therefore underestimate the probability that it could happen to us. In reality, most disabilities are partial and invisible, but they can have a huge impact on our financial wherewithal.