How to Protect Your Biggest Asset–Your Income

The Most Complex Insurance Explained, Part 1

Originally published CNBCYou’ve got a machine just sitting around your house. 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 that 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, easily making it your most valuable asset today.

printing_money_for_aig_xlargeYet there it sits, maybe 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. 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 of us know if—or at least how and to what degree—their income-generation engine is protected.

Do you?

This post is the second in a two-part series.  You can read the second on Long-Term Care (LTC) by clicking HERE.

Disability Income Insurance Primer

The insurance product that helps protect your income in the case of a disabling injury is disability income insurance. Although, according to Carol Harnett, 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. You can’t assume that your group coverage is sufficient. Indeed, most group coverage isn’t.

A short-term policy is helpful, but it isn’t necessary if you have adequate emergency cash reserves. It most often supports the extended absence of a new mother. Apparently, the miracle of birth is considered a disabling injury—who knew? The long-term policy is the one that we’ll focus on, because it deals with the larger risk exposure.

There are a maddening number of moving parts in disability income insurance policies. 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) will not pledge a base benefit higher than 60 percent of your pre-disability income (after tax), lest policyholders become incentivized to conjure up mystical disabilities.
  • Benefit period—This is the maximum length for which your disability income insurance policy will pay benefits. A “lifetime” benefit typically only extends 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 only kicks in 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—whose job it is to ensure their firms remain profitable—it understandably feels like a “gotcha” for consumers.
  • Renewability provision—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 benefits by the amount of any Social Security disability benefit you happen to receive. Accepting the Social Security offset should reduce your premium without increasing your risk.

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 Wal-Mart 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, and that’s why there is 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 LTD policies are very limited in that pesky definition of 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, you’re likely to lose your coverage.

Disability and Taxes

Even if you’re within the first two years, please note that it is likely that you are 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—after-tax. While 60 percent after-tax is likely to be less than you received in your paycheck before your disability—especially when considering the likelihood of increased medical expenses—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 the expense of your group LTD premiums as a business expense—and most are—the benefit to you would be taxable. Yes, the IRS only allows a tax break on one end of this equation. This means your 60 percent disability income insurance benefit would really equate to more like 40 percent, 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,” said Zack Pace, senior vice president of benefits consulting at CBIZ. 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?

Simple Money LTD Guide

For a majority of workers, the limitations of their group or company-sponsored long-term disability income insurance policy are sufficient to warrant subsidizing the work policy with a private, supplemental policy. This supplemental policy should have more robust features than the group policy.

While each person’s situation is different and exceptions abound, consider the following list of minimum provisions to include in your supplemental policy:

  • Base benefit—60 percent of predisability income; higher, if available.
  • Benefit period—To age 65 would be great, but at least five years.
  • Residual benefit—You want this provision; most claims are partial.
  • Elimination period—90 or even 120 days if you can afford it.
  • COLA—If you’re in your 50s, you might opt out, but if you’re younger, you’ll want this.
  • Future insurability options—Some policies include this, but if not, you want the rider.
  • Renewability provision—Non-cancelable/guaranteed renewable is ideal.
  • Social Security offset—May complicate claims, but it will help save on premiums.
  • Disability definition—Any-occupation is too weak, but pure own-occupation can be excessively expensive; consider “modified own-occupation,” “income replacement” or the equivalent.

With this disability income guide, you should be able to utilize this free online comparison tool to analyze any current coverage and obtain apples-to-apples quotes for any new coverage needs.

When dealing with any insurance, your goal shouldn’t be to cover all risks. Hopefully, you’re insulated enough with adequate emergency reserves to eliminate some small risks inherent in the case of a disability. Or, for that matter, a fender-bender, small kitchen fire or minor health issues and the like. Self-insure the risks you can handle and use insurance for more catastrophic risks. This helps keep household insurance costs to a reasonable level.

Speaking of catastrophic risks, what if you’re self-employed or working for a company that doesn’t offer any group LTD coverage? That means you’re on your own. The good news is that at least you’ll be able to create a policy with better characteristics than the typical group policy.

The bad news is that good coverage doesn’t come cheap. And good coverage is the only kind you want. “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.

Although it’s confusing, misunderstood and underappreciated, long-term disability income insurance is simply “the cost of doing business.” Especially if you’re in your 30s or 40s and your future income is your largest asset. After all, you’ve got to insure that money-printing machine in the garage.

If your mind isn’t already spinning,  you can read the part two in this two-part series on Long-Term Care (LTC) by clicking HERE.