How Disability Insurance Works (When You Can't)

One topic that often is overlooked when it comes to personal finances is risk exposure.  Risk is why all sorts of insurance products exist.  Sure, we know we need car insurance in case we are in an accident and medical insurance in case we have an accident or severe illness.  These types of insurance policies protect our financial assets and can prevent financial ruin.

If you are young and healthy, your most valuable asset isn’t your car or even your home, but your ability to earn an income.  This is known as human capital and we previously wrote about its importance in wealth creation.  The purpose of disability insurance is to replace part of your income when you can’t work due to illness or injury.

REVIEW YOUR DISABILITY COVERAGE AT WORK

If you work for a large company, chances are good that your benefits package includes some form of disability insurance.  There is short-term disability that pays part of your salary if you are out of work for a short period of time, say to recover from an accident, surgery or having a baby.  There also is long-term disability insurance.  It pays part of your salary if you are out of work for an extended period of time like three to six months or longer.

HOW MUCH OF MY INCOME WOULD BE REPLACED?

With employer-provided disability coverage, it’s common for the benefits to replace 50-60 percent of your base salary.  It does not cover bonuses or commissions.  Any benefits collected under employer-provided policies will be further reduced by taxes.  However, if you buy additional coverage through your employer on a “voluntary” basis, some of the benefits collected from a disability claim will be tax free.

Why does it pay only part of your salary?  Because the insurance company wants you to have an incentive to go back to work so they can stop paying benefits.

WHAT ARE MY CHANCES OF BECOMING DISABLED?

Consider these statistics:

• 1 in 4 people who are 20 years old now will be disabled before reaching retirement age
• The average duration of a disability claim is nearly 3 years

How would your financial situation change if you were unable to collect a paycheck for 3 years?  The chart below shows how wage earners anticipate paying  their bills  in case of a disability.

Accidents are not the main culprit. The majority of long-term absences from work are due to back injuries, cancer and other illnesses.  The #1 cause of long-term disability is musculoskeletal disorders like back pain, spine/joint disorders, arthritis, etc.  Most are not work accidents, so workers compensation won’t cover you.

WHAT IF I’M NOT COVERED AT WORK?

If you don’t have disability insurance where you work, or if the coverage is minimal, you can purchase an individual policy.  These policies are more expensive than group insurance policies available to employers.  The cost is based on your medical history and your age at the time the policy is issued.  Premiums are generally fixed, so the younger you are when you purchase a policy the lower the cost will be.

IMPORTANT DETAILS TO KNOW

When reviewing the details of a long-term disability policy, pay attention to these factors:

• Waiting period before benefits start (also called elimination period)
• How long do benefits continue? If you are permanently disabled, payments usually stop at “normal retirement age”
• Inflation adjustments or cost of living increases

Any provision that is in your favor is likely to increase the premiums you pay.

Another option known as “own occupation” coverage is especially important to high earners in specialty fields like medicine.  Basic long-term disability policies, including those offered by employers, will refuse to pay benefits if you are able to do any work even if you can’t do your previous job.  This is referred to as “any occupation” coverage.  An own occupation provision is the best to have, especially in the case of a total disability, as it will provide benefits if you are unable to work in your previous field, but able to do other types of work.

It’s a good idea to do a personal risk assessment annually at your benefits enrollment time.  Consider who is depending on your paycheck as well as where the money would come from if your paychecks stopped.