Remember what it was like to be 20? At that time, you were probably thinking more about plans for the weekend than plans for the future. You likely weren’t too concerned about life’s “what ifs.” Maybe that’s a good thing, considering that some of those “what ifs” are a little scary. Take this one for example: More than 1 out of every 4 of today’s 20-year-olds will become disabled before they retire, according to the Social Security Administration. Now that puts a damper on the weekend plans.
You may already know the importance of disability insurance coverage, and how it can benefit your employees. But if you haven’t delved too deeply into disability insurance, you should probably understand the basics. And, there are a few new twists out there you may not have heard about yet.
First, the basics.
Group short-term or long-term disability insurance
- Disability insurance is available to cover short- or long-term disabilities. Both short- and long-term disability insurance is designed to replace a portion of the employee’s income while sick or hurt and unable to work. Short-term disability coverage may begin soon after the onset of the illness or injury that triggers the claim, and continue for several weeks. Long-term coverage is for extended periods of illness or injury. The waiting period for it to begin is longer, as is the period during which payments will be made to the employee.
- A typical group STD plan may have, for example, a waiting period of 7 days, after which the policy will pay benefits for up to 26 weeks. A group LTD plan may require 90 or 180 days for the waiting period, with payments continuing monthly until age 65 or Social Security age. The premiums are based on a number of factors, including how many employees will be covered, the industry, the amount of coverage, the definition of total disability, and the waiting and benefit payment periods.
- Because of all these variables, it is very important to understand how disability is defined, what is considered covered earnings, and the specific conditions under which policy benefits become payable – including whether or not the policy is considered secondary to Social Security or State disability or Workers Compensation plans, as well as any exclusions.
- Disability insurance is designed to protect only a portion of an individual’s compensation, generally about two-thirds of income. The insurance company will want to know about other policies that may be in force so they can be sure the individual is not over-insured. The reasoning is that people who receive more money when they are disabled than they did when they worked will be less motivated to recover and get back to the job.
Employer-paid or employee-paid
You may offer your employees some disability coverage and pay for it as an employee benefit. When you do, the premiums you pay are deductible as a business expense and do not cost the employee anything. However, when the employee receives disability payments under an employer-paid policy, those benefit payments are taxable as income to the employee.
Conversely, if you as an employer only offer employees the opportunity to purchase individual disability policies at work, or if the employee purchases the coverage another way on his or her own, the premiums are not deductible to the company. Then, if benefit payments are made under the policy, they are not taxable to the individual.
Disability insurance not designed to cover everything
Disability insurance, in its various forms, has existed for a long time. But over the last decade or so there has been a significant new development. Susie Tan is Director of Sales in the Multi-Life Disability Division at Guardian Life (www.GuardianLife.com), and we asked her about it.
“If someone becomes sick or hurt and unable to work, their paycheck stops,” she says. “Most group disability plans protect roughly 50 to 60% of a person’s base salary only – it often does not include bonuses or commissions. And there are caps, or maximums, to how much benefit one can receive. Those are usually fine for a lower-paid employee. But when you become highly compensated, those benefit maximums are fairly detrimental to how much of your income you can receive during periods of disability.”
The problem, of course, becomes how to pay the bills during what could be a long-term situation. Tan says, “The average length of a disability is 31 months. So not only do you have a shortfall in your regular base salary, but your bonuses aren’t covered at all. And if the employer is paying for the insurance, the benefits are taxable to you.”
Disability coverage for 401(k) contributions
But there is another problem many people will face if they become disabled, Tan says. “If you are sick or hurt and unable to work, not only does your paycheck stop, but you’re not making any more contributions to your 401(k) plan. When your contribution stops, your employer match stops, too. So if you fall into that average for the length of a disability, you’re losing a lot of potential for your retirement savings.
“Even worse, because you’re no longer getting the compensation you have been used to, what often happens if people start to raid their retirement savings. Then, when you recover and you’re ready to go back to work, is your job even available? In this market, it can be difficult. And if you do get your job back, or find another one, will be receive the same level of pay as before? All of this can have a serious impact on your eventual retirement.”
To illustrate the potential loss of savings, Tan uses an example of a 35-year-old who is deferring $2,000 a month into a 401(k) plan. Assuming an annual rate of return of 8% and no disbursements before age 65, the individual’s retirement account balance would grow to $2,980,719 at age 65. If the employee became disabled after joining the plan and making his $2,000 monthly deferrals for just one year, and if that disability continued to age 65, the account balance would grow to only $251,430 based on the same rate of return.
“In this illustration, if the employee had purchased a disability policy that specifically covers retirement contributions – like the Retirement Protection Plus that Guardian offers – this employee would have more than $2.6 million at age 65. Quite a big difference, for about $60 a month in premium.”
“This kind of coverage works with any defined contribution plan to which the employee contributes, like a 403(b), profit sharing or 457 plan, too,” Tan continues. “The policy continues the contribution you have insured, paying it into a trust you establish, and will be invested based on your direction. You can cover up to the annual addition limits under the Internal Revenue Code, which for 2012, is $50,000 for those under age 50 and $55,500 for those who are taking advantage of catch-up contribution provisions at age 50 and over.”
“The question with disability isn’t really whether or not it will happen – we know statistically that it will, to many, many people,” Tan says. “In fact, statistics show that one in five workers will be disabled for 5 years or more during their working lives. The bigger question for people to think about is, really, if it happens to them, will they have enough money to cover their expenses and at the same time continue to fund their retirement savings plans? If yes, for how long?”
If not, Tan suggests that employees speak with a trusted financial advisor or insurance agent about enhancing their disability benefits at the workplace. “Considering the plethora of excellent disability income protection programs now available in today’s market, there is no reason for people to become financially devastated during their most critical time of need.”