When is the best time to buy disability insurance?
The day before you need it, of course.
For life insurance, it’s the day before you die. For homeowners insurance, it’s the day before your house catches on fire and burns to the ground. For health insurance, it’s the day before you get sick and need care.
The problem is that no one knows when any of these days will occur, which is why people buy the insurance and maintain it for as long as they need the protection.
Many people buy homeowners or renters insurance, car insurance, and health insurance.
Unfortunately, very few people proactively look at their disability insurance and buy an individual policy if they do not have group disability insurance or their group disability insurance protection is not very good.
I’ve always been frustrated by it. If you make $60,000 a year, never get a single raise, and work forty years, that’s $2,400,000 in earnings. Yet, some people buy cell phone protection for a $1,000 phone. Which do you want to protect?
Plus, the odds of getting disabled are not insignificant. More than one in four of today’s 20-year-olds can expect to become disabled before reaching retirement age, according to the Social Security Administration.
The cause of a disability may also surprise people. The most common reasons for long-term disability claims are musculoskeletal disorders (29%), cancer (15%), pregnancy (9.4%), mental health issues (9.1%), and injuries (9%).
Nobody ever thinks they will become disabled, and I’ve found most people never look at their disability insurance until they hear about a friend who becomes disabled.
If you need a few stories to scare you, let me tell you a few.
- A man has a stroke, survives, but can no longer work full-time as he had before. He has difficulty focusing, can’t work as fast, and cannot be trusted with the same responsibilities as he was doing before.
- A woman was hit by a bus, suffers a spinal cord injury, and has complete paraplegia. She has years of recovery, can no longer work in her previous career, and the job opportunities are very limited.
- A man gets Non-Hodgkin Lymphoma, cannot work during treatment, goes back to work after it is treated, and then cancer comes back again.
None of these people were “old” when they became disabled. The ages range from the mid-20s to late 40s.
If you think you are immune because you are young, you are wrong.
You can become disabled as a younger person and since you have more earning years ahead of you, disability insurance is even more important. For example, if you are age 50 and going to retire in 10 years, you only have 10 years of earnings you need to protect; however, if you are 25 and retiring at age 60, you have 35 years of earnings to protect.
Let’s explore what disability insurance protects, common riders, how much coverage is reasonable, and a real world example.
What is Disability Insurance?
Disability insurance protects your income. It can replace a portion of your lost earnings if you are disabled and unable to work.
There are two main types of disability insurance: short-term and long-term.
Short-term typically pays benefits for a few months to one year. Long-term typically pays for a certain number of years or until age 65 if the disability continues.
There are a few ways to obtain disability insurance:
- Group employer plan
- Professional associations
- Individual policies
If your employer offers coverage, sometimes they pay the premium, and other times you are responsible for paying the premium. Generally, I like when the individual is responsible for paying the premium because if they ever became disabled, the benefits would be tax-free. If the employer pays the premium, the benefits are taxable.
I know it seems weird to want to pay for the disability insurance, but employers will sometimes increase your salary to cover the cost. It’s beneficial to pay the premiums because if you become disabled and the policy starts to pay, the difference in benefits you receive can vary drastically.
For example, if you paid the premiums and were receiving $5,000 per month, you get to keep the full $5,000 because it is not taxable. If the employer paid the premium, you would owe income tax on the amount. If your effective rate was 15%, that’s only $4,250 per month.
Group employer plans and professional associations normally offer cheaper disability insurance policies, but the downside is if you leave your employer or the professional association, you typically cannot take the policy with you, which means you could be left without coverage.
An individual policy is nice because, regardless of what your employer offers or whether a policy is offered by a professional association you belong to, you can have coverage. The downside is that it is more expensive. An individual policy might cost 3-4% of your annual income. For example, if you make $60,000 per year, an individual disability insurance policy may cost $1,800 – $2,400.
The cost depends on your age, health, gender, occupation, location, and a variety of other factors.
If you are still thinking, “Should I have disability insurance?”, let me make this simple for you.
Are you financially independent? If not, you likely need disability insurance. Basically, anybody with earnings who is not financially independent likely should have disability insurance. What happens if you become disabled and cannot work?
And, if you think Social Security Disability Insurance or worker’s compensation insurance is going to cover you, they probably won’t. Both provide very limited coverage in only certain circumstances.
Let’s look at common riders on disability insurance policies.
A rider is an added feature or enhancement you can add to a policy that provides extra benefits. Most disability insurance policies start with a standard policy, but you may not want the standard options the same way most people don’t want standard car options. They want to add extra features to better suit their lives. This is where riders come into play.
There are many different types of riders, but these are some of the important ones.
The definition of disability is very important. If your policy says “any occupation”, the policy would only pay benefits if you were unable to work in any job.
If your policy was “own occupation”, a policy would pay benefits if you were unable to perform the material duties of your specific occupation. This is a more generous definition of disability.
I strongly favor “own occupation” policies because if you had an “any occupation” definition, the policy may not pay benefits as long as you can work in any job. It doesn’t matter whether it’s related to your training and work history.
Non-cancelable means the insurance company can’t cancel your policy, and the premium won’t change, as long as you keep the policy in force. This is important because you do not want to start a policy in your 20s only to have the possibility of the premiums rising in your 40s if the insurance company wants to re-price the policy.
Guaranteed renewable means the terms of your policy can’t be changed. Many policies are offered as non-cancellable and guaranteed renewable. I favor these policies because you are locking in your rights for the life of the policy.
Partial or Residual Disability Benefit
The partial disability benefit is an added feature that if you are still working, but suffer a loss of income, usually 15% or 20%, the policy will pay benefits. This is really important because some disabilities can lead to working less, but still being able to work. For example, perhaps you become disabled, but still can work and your income goes down 60%. In that scenario, your policy likely won’t pay benefits unless you have a partial disability benefit rider.
Cost of Living Adjustment (COLA)
Do you remember how some things were really inexpensive growing up and now they seem expensive? Over time, inflation can add up and increase the price of things. The cost of living adjustment increases the monthly benefit you receive while claiming disability insurance benefits, usually subject to the Consumer Price Index or a certain percentage, such as 3%. This rider is very important for younger people because if you go on claim and get $5,000 a month today, that same $5,000 won’t buy very much in your 50s.
Future Purchase Option
The future purchase option allows you to purchase additional coverage in the future without needing to provide evidence of medical insurability. This one is really important if you anticipate your earnings increasing in the future. If you need to purchase additional coverage in the future and did not have this rider, you would need to apply for another policy. If you had a health event that disqualified you from obtaining coverage, you may not be able to buy the policy.
This one is particularly important for medical residents, or physicians in their early years of training, because they usually start off with a small benefit relative to their future earnings. For example, they may buy a $5,000 monthly benefit, but once they are an attending, their salary may increase 3-10x their resident salary, and the original $5,000 monthly benefit may be inadequate. If they did not have a future purchase option, they would need to apply for additional coverage, which they may be unable to attain if there had been an unfortunate event in the interim, disqualifying them for a new policy.
The future purchase option can come in two flavors: future increase option or benefit update rider. The options vary by insurer, but typically, the future increase rider allows you the option to increase your coverage annually or during certain qualifying events, such as losing employer-provided group disability coverage. The benefit update rider typically requires you to submit financial information every three years and if you are eligible for an increase, you need to accept at least 50% of the increase or you lose the option to increase it in the future. Again, each company is a little different, but this gives you an idea of how it can work.
How Much Coverage is Reasonable?
Disability insurance typically limits how much coverage you can purchase. Usually, it’s 60-70% of your income. They do not want to provide an incentive to become disabled, not work, and earn as much as you were while working.
Personally, I try to insure as close to 60% as possible. Most people simply become accustomed to their income and would have a very hard time reducing their lifestyle if they became disabled. If anything, a disability might require more spending to make accommodations for your new normal.
Many employer plans limit the maximum amount of coverage. For example, some might say they pay 60% of your income up to $5,000. What this means in practice is if you make $10,000 per month, 60% would be $6,000, but the policy will not pay more than $5,000.
Sometimes, people will buy an individual policy to bridge the gap. For example, they may have group coverage and an individual policy that will cover the $1,000 that the group policy would not pay.
There is no right answer for how much coverage is reasonable. You need to look at your own life and spending and determine if the coverage you have in place would provide enough benefits for you and your family if you became disabled. Don’t forget to check if the benefits would be taxable! If they are taxable, you may want to find a way to increase your coverage.
Real World Example
How does this all come together? The following example shows the types of decisions involved in determining which policy is right for you.
Say we have a medical student – we’ll call her Dr. Funnybone – who is graduating soon and will continue her training as a resident physician.
Her program provides group disability insurance coverage, but she decides to obtain an individual policy because the group policy did not offer the option of “own occupation” coverage. Plus, she reasons that most doctors should have their own individual policy anyway; it offers greater customization, follows you wherever your career takes you, which means you are not dependent on group coverage, and can lock in your coverage regardless of what happens to you.
Dr. Funnybone speaks with an insurance agent who provides quotes from five different insurers. There are typically six big insurers in the disability insurance space. She excluded one because they are a smaller insurer in the disability insurance space.
Further, she hopes to balance both the cost and the coverage of the policy, so looks at each policy very carefully. As a medical resident, she finds out that she automatically qualifies to purchase a $5,000 monthly benefit from insurance companies even though that’s more than 60% of her income. This is a special thing for physicians because the insurance company recognizes future earning potential for doctors. She opts for the $5,000 monthly benefit even though she could purchase a lesser amount. If the budget had been tighter, she reasons that she could have selected a lower monthly benefit; however, because of her debt from student loans and the uncertainty of what life could look like with a disability, she decides on obtaining the maximum coverage available.
All of the quotes she receives from the five companies are non-cancelable, guaranteed renewable, and own-occupation. Dr. Funnybone is happy about this, as she wanted to lock in her coverage so that it would not change later. She knows that the “own occupation” portion of the policy is important – if she were to become disabled in the future and had been primarily working directly with patients, the policy would still pay benefits if she were disabled, couldn’t work with patients, but wanted to do another aspect of medicine, such as lecture students.
She decides to opt for the enhanced partial disability benefit rider. It is important to her that even if she returned to work, but had a loss of income, it would pay benefits.
Dr. Funnybone also opts for a future insurability option rider, which allows her to increase her monthly benefit in the future. Instead of the future increase option, she selects the benefit update rider, because it has cheaper premiums. She feels comfortable with the idea that every three years she will be required to submit financial documentation to show her current income and accept at least 50% of any offer. For example, if she was offered an additional $5,000 in monthly benefit in three years, she would need to accept $2,500 to keep the benefit update rider on the policy. If she chose not to accept $2,500, she would never be able to increase the monthly benefit again in the future unless she applied for a new policy. She knows that others might choose the future increase option over the benefit update rider for more flexibility, but she feels this is the right plan for her.
Dr. Funnybone also has the option of a graded monthly premium or a fixed level monthly premium. A graded monthly premium starts off cheaper, which is helpful as a resident, but then in later years is more expensive. Over the life of the policy, she would end up paying more. She opts for the fixed level premium because it fits in the budget and will likely mean less in total payments.
Many policies cap disability payments for mental, nervous, and substance abuse claims at 24 months. Many insurance companies allow you to remove the cap, but offer a discount if you keep it on the policy. Dr. Funnybone chooses not to take the discount and removes this limit from her policy, meaning if she has a mental, nervous, or substance abuse claim, the monthly benefit payout would not be subject to a 24-month cap. Although she is not expecting to have any mental health issues in the future, disability insurance is for things you never imagine will happen to you. And, Dr. Funnybone likes to plan for the unexpected.
She also selects an insurance company that is willing to pay benefits even if she was disabled and lived abroad. Not every insurance company does this – some require you to live in the United States for the majority of the year. Although this may not seem important to some people, she likes the option of being able to travel somewhere else and live in another country. As an aside, I don’t know how feasible it would be to live abroad while being disabled, and it largely depends on the disability, but I know I would want the option.
Toward the end of researching her options and speaking with her agent, she finds out that she gets a 20% discount because of her employment. Her insurance agent tells her that some discounts are offered through her medical school and others through her employer. If you are applying, sometimes you can get a multi-life discount (10-20%) if you have three or more people applying for coverage from the same employer. Your insurance agent can help you with these discounts. This can be helpful, particularly for women, because their disability insurance tends to be more expensive than men because they tend to have more claims. It’s the exact opposite of life insurance where it tends to be more expensive for men because they tend to die sooner.
Although not an easy or short process, Dr. Funnybone is happy that she worked with an insurance agent who specializes in working with doctors. He answered her questions and guided her to the right policy for her. Now, she begins the application process, underwriting, and hopefully putting the policy into place.
Summary – Final Thoughts
I would argue disability insurance is one of the most important insurance coverages. Most people’s earnings are their biggest asset. After all, most people cannot go months, years, or possibly decades without income.
There are many nuances to disability insurance and plenty of jargon. It’s important to take the time to understand the jargon, review your available options through your employment or professional associations, or work with an insurance agent who can help guide you to something that will fit your life.
My challenge to you is to review your current disability insurance coverage and answer the following questions:
- What definition of disability insurance is your policy (i.e. own occupation or any occupation)?
- What is the maximum monthly benefit?
- How is the monthly benefit calculated (i.e. is it last year’s income or an average of the last few years)?
- Are there other riders?
- If you were disabled today, do you have enough coverage?
I wish you the best in reviewing your policy.