Disability income: the forgotten insurance.

Many clients assume that, if they become disabled, benefits from employer-provided group disability insurance and Social Security will give them sufficient income until they are able to return to work. But benefits from these sources are often inadequate, particularly in the case of long-term disability.

Almost everyone understands the need to maintain sufficient life insurance to protect his or her family. But the likelihood of an individual between the ages of 25 and 50 being disabled for 90 days or longer is about three times that of dying. And 30% of all disabilities are permanent.

Despite these statistics, clients rarely plan for long-term disability. Fewer than one in six clients has adequate disability coverage. Those who fail to do the proper planning don't understand the potentially disasterous financial implications of becoming permanently disabled. The role of the CPA is to inform clients of the need for disability insurance coverage and to help them cloose from among the many different policies offered today.

DISABILITY INCOME

INSURANCE

Disability income insurance is a form of health insurance that provides periodic payments to the insured when he or she is unable to work because of illness or injury. Typically, ongoing family living expenses and new medical expenses exceed the income available from personal investments, spouse's earnings and employer-provided disability protection.

Disability income insurance policies can be classified broadly as either short or long term. Short-term coverage, often provided as an employer-sponsored group benefit, is designed to protect against temporary disability, which can last from six months to two years. Long-term policies more typically are maintained by the individual (although some employers do offer this coverage) and can provide benefits for 5, 10 or 20 years, to age 65 or for life.

INCOME TAX IMPLICATIONS

The CPA should be certain clients understand the income tax consequences of disability insurance benefits. Benefits are taxable if the employer pays the premium. Benefits from personally maintained coverage are tax free. CPAs frequently recommend the employee pay the premium or reimburse the employer for any premium cost, so the benefits will be free of federal income tax when they are received.

DEFINITION OF DISABILITY

The most important factor to consider in purchasing disability insurance is the policy's definition of "disability." The more liberal the definition, the better--and more expensive--the coverage is for the client. A policy that defines disability as the inability to perform one's own occupation means the insured is considered disabled and eligible for benefits if he is unable to engage in any and all duties of his own occupation. For example, a surgeon who can no longer perform surgery will receive benefits even if he can still teach.

Such a policy is preferable to one that provides benefits only if the insured is unable to perform any occupation for which he is reasonably qualified or even to perform any occupation. With the former, a surgeon who still could teach would not be eligible for benefits by reason of being able to perform an occupation for which he was reasonably qualified. In the latter case, a surgeon who could perform any occupation (such as stuffing envelopes) would not be eligible for benefits. Policies of either of these types are less expensive than those that will pay benefits when the insured is unable to perform his own occupation.

HOW MUCH INSURANCE?

As a rule of thumb, a client should have disability insurance benefits equal to 60% of his monthly income. In fact, insurance companies rarely will insure an individual for more than that amount because they do not want to damage the insured's incentive to return to work. It also usually is recommended that clients not depend on benefits from Social Security Disability Insurance (SSDI) because over 70% of people who apply for such benefits are rejected. Under the Social Security Administration's definition of disability, an individual would have to be so severely mentally or physically disabled that he could not perform any substantial gainful employment. In addition, the disability must be expected to last for at least 12 months or to result in earlier death, based on medical evidence.

In determining both the appropriate amount of disability coverage and waiting period, it's also important for the client to assess his other financial resources. This would include the ability of his spouse to work, available assets and any other sources of income. For example, if the client has a reserve fund equal to three months' living expenses (most practitioners recommend an emergency fund of at least three to six months' living expenses) the policy waiting period can be selected accordingly. A longer waiting period will reduce the cost of the coverage.

SELECTING DISABILITY

COVERAGE

Beyond choosing the amount of disability coverage, a client also will be faced with a number of other alternatives, many of them in the form of riders on the basic policy. Following is a list of riders and other features that should be considered in evaluating a disability policy.

Waiting period. The waiting, or elimination, period on a disability policy is the equivalent of a deductible on medical insurance coverage. The client will have to wait a specified number of days before benefits begin. As noted earlier, a client with sufficient liquid reserves might select a 90-day waiting period. The longer the waiting period selected, the lower the applicable premium.

If possible, the client's long-term disability coverage should coordinate with short-term coverage so there is no gap in benefits. For example, a client with group coverage that provides benefits for only 60 days should select a 60-day waiting period on his individual long-term policy.

Guaranteed renewable. With this feature, the client has the right to keep his disability policy in force (by timely payment of premiums) up to a specified age, such as 65. The insurance company cannot cancel or rewrite any of the policy provisions, with the exception of increasing the premiums for an entire class of policyholders to which the insured belongs. Such a provision is an important feature.

Noncancelable policy. With a noncancelable policy, the client has the right to renew his policy for a stated number of years or until a stated age, at the same guaranteed premium. As with the guaranteed renewable feature, these provisions are included in better disability policies and should be taken if offered.

Residual benefits. Following their recovery from an illness or injury, some clients are still unable to return to work on a full-time basis. Residual benefits allow the client to make up some of the lost income. This provision will pay a percentage of the maximum policy amount--often for the life of the policy--while the client is working part-time or until he resumes full-time work.

Guaranteed future insurability. This provision periodically allows the client to increase coverage in line with salary increases, up to a stated age, with no new evidence of insurability. This benefit is inexpensive and can be important because it protects a client's future earning power if he becomes uninsurable.

Cost of living adjustment (COLA). This rider is designed to protect a client from a loss of purchasing power if he is disabled for more than one year. Beginning in the second year, the COLA provides annual increases for each year the client receives benefits. This can be a valuable option for those purchasing long-term protection (particularly younger clients) for which inflation can reduce benefits substantially.

Waiver of premium. Generally, most disability income policies offer a waiver of premium after 90 days, with a full refund of premiums for the original 90-day period. A waiver of premium provision exempts the insured from paying premiums during the period of disability.

DURATION OF BENEFITS

Clients should take the longest benefit period the insurer offers in order to receive maximum long-term protection. Under most circumstances, the best policy would provide benefits until age 65. Coverage beyond that age is usually not necessary since, at that time, income will become available from pension and Social Security retirement benefits.

SPECIAL NEEDS OF SMALL

BUSINESS OWNERS

In addition to meeting their own and their families' income needs, small business owners often have special needs in the event of a prolonged disability. If there is no one else available to run the business (as in the case of a sole proprietor) the client might also want to consider business overhead expense insurance. This is a type of disability income insurance that protects the small business owner if the business has to be closed as a result of disability. This coverage also would provide funds for expenses such as rent, employee salaries, utilities, insurance premiums and similar fixed expenses of operating the business in the owner's absence. Meeting these expenses can help a business remain a going concern until the owner is able to return to work or the business is sold.

COST OF DISABILITY

COVERAGE

The cost of disability income protection is based on a client's age, occupation and sex, as well as on the provisions discussed above, such as benefit term, waiting period and the dollar amount of the benefit itself. It generally pays for a client to shop around to find the least expensive coverage that includes the features important to his situation. Failure to obtain proper coverage means the client is gambling with a most valuable asset--future earning power.

Jeffrey H. Rattiner, CPA a technical manager in the American Institute of CPAs personal financial planning division, discusses how to evaluate a client's purchase of individual disability insurance.