How to mitigate the risks of a long-term disability event.

Since May is Disability Insurance Awareness month, I’ll discuss how to mitigate the risks of a disability event.  Short-term disabilities can be planned for by having a well-funded emergency fund (3-6 months’ worth of essential expenses) or short-term disability coverage through your employer.  Therefore, I will focus this blog post on mitigating the risks of longer-term disabilities (6 months or longer).

Long-term disability planning is often overlooked within a financial plan because most people assume they are covered through their employee benefits.  As you will read below, the amount of coverage and the type of policy needed can vary significantly depending on your situation, so it’s important to do a thorough needs analysis. 

First, to understand what you are planning for and what you are protecting against, let me explain the outstanding risks by listing some facts about disability:

• According to the Social Security Administration, one in four of today’s 20-year-olds can expect to be out of work for at least one year because of a disabling condition before they reach the normal retirement age.*
• According to a Gen Re 2011 survey, the average long-term disability insurance claim lasts around 2.5 years.**
• Injuries, such as fractures, sprains, and muscle/ligament strains account for about only 12% of disability insurance claims. Musculoskeletal diseases (27.6%), cancer (15%), mental health issues (9.3%), and cardiovascular diseases (8.2%) account for the rest.***

What is considered being disabled?

In general, disability is defined as a physical or mental condition that prevents an individual from performing the duties of their occupation or any occupation for which they are qualified.  There are two primary types of disabilities:

• Own occupation: The own occupation definition of disability considers an individual disabled if they are unable to perform the material and substantial duties of their own occupation, regardless of whether they are able to work in another occupation.
• Any occupation: The any occupation definition of disability considers an individual disabled if they are unable to perform the material and substantial duties of any occupation for which they are qualified based on their education, training, or experience.

Let’s use an example of a litigation attorney to dig further into these definitions.  And let’s assume one of this attorney’s main duties is to argue cases in court.  If she becomes disabled enough and can no longer go to court, she technically would be unable to perform the material and substantial duties of her own occupation even though she might still be able to perform administrative duties at her firm.  In this case, she would likely qualify for disability benefits with an own occupation definition.  However, if she had an any occupation definition on her disability policy, since she is able to perform other duties at her firm in which she is qualified based on her education, training, or experience, there is a chance her claim could be denied.

Now that we understand what disability is and what risks attorneys face, let’s dive into how to plan for a long-term disability event.

4-step process to mitigate the risk of long-term disability

1. Create a budget: If you haven’t done so already, creating a budget will help you understand where your money is being allocated. From there, separate your expenses between essential expenses (mortgage payment, utilities, groceries, debt repayment, etc.) and discretionary expenses (travel, restaurants, entertainment, etc.).  The reason for this is if you became disabled, you would likely not travel the world or go on a shopping spree, so it is not necessary to insure against discretionary expenses.

2. Determine your coverage need: Your disability coverage should be at a minimum equal to the essential expenses portion of your budget. For example, if your essential expenses add up to $10,000/month, your disability insurance policy should cover at a minimum $10,000/month after taxes. 

3. Analyze your current coverage: To determine whether you need additional coverage, you need to analyze your current policy. Below are the major components of a disability policy:
   1. Monthly benefit: Disability insurance policies either cover a percentage of your salary (usually 50-70% of your gross salary) or a flat amount. Note that if you are a high earner, workplace disability benefits might be capped after you reach a certain level of income (e.g., 60% of salary up to $20,000/month of coverage).
   2. Elimination period: This is how long you would have to be disabled before the policy benefits kick in (usually 90 days). Think of the elimination period as your deductible.

• Benefit period: This is how long the benefits would last if you were on claim. The benefit period typically ranges from two years up to when you attain the age of 67.

1. Definition of disability: As mentioned above, the definition of disability is key in determining whether you are eligible for benefits. Would your policy cover you if you weren’t able to perform your “own” occupation or “any” occupation? Note that some disability policies will have a blended definition, meaning the own occupation definition is true for a limited number of years (e.g., 2 years), then the any occupation definition kicks in thereafter. 
2. Premiums: Is your employer paying for the premium, or are you paying it with after-tax deductions? This will determine whether your benefit, or a portion of your benefit, is taxable (see below regarding taxation of disability insurance benefits).

4. Purchase additional coverage, if needed: If you need additional coverage, you will need to purchase it either through your employer (as a supplemental policy) or as an individual policy. In either case, some medical or financial underwriting may be required.  Note that you will never be able to cover 100 percent of your salary because insurance companies don’t want people to have an incentive to not work. 

Taxation of disability insurance benefits

If your employer pays for 100 percent of the premium, your entire benefit will be considered taxable income.  Vice versa, if you pay for 100 percent of the premium, your benefit will be tax free.  In the case where both you and your employer contribute towards the premium, the taxable amount of the benefit will be proportionate to the percentage of the premium paid by your employer.  For example, if your employer pays for 50 percent of the premium, 50 percent of the benefit will be considered taxable income and 50 percent will be tax free.  Individual policies will always be tax free because they are paid by you with after-tax dollars.

Sources:

* https://www.ssa.gov/news/press/factsheets/basicfact-alt.pdf

**https://www.limra.com/siteassets/newsroom/fact-tank/fact-sheets/diam-2021-final.pdf

***https://disabilitycanhappen.org/public_html/wp-content/themes/cdadev/images/disability_stats.pdf

Neither SharpEdge Financial LLC, NYLIFE Securities/Eagle Strategies nor its representatives, provides tax, legal, or accounting advice. Please consult your own tax, legal, or accounting professional before making any decisions.