When discussing disability insurance, particularly as it refers to highly-compensated employees and professionals, there appears to be a distinct lack of understanding of the mechanics of disability income insurance coverage. Whether it’s an office worker or an executive, almost everyone says, “I didn’t realize that.”
Corporate executives, business owners, money managers, lawyers and others firmly believe that they are adequately protected and that their company’s disability income plan provides them with 60 percent coverage. In other words, they are firmly convinced that, should they become disabled, they will receive 60 percent of their annual compensation. That is their perception. Unfortunately, in the world of disability benefits for highly-compensated individuals, perception is definitely not reality.
Recently I met with the head of the human resources department of a large public company, and soon the conversation turned to a discussion about their disability insurance coverage.
“So,” I asked, “how much disability insurance does the company provide for its employees?” He replied, “We offer 60 percent income replacement to a maximum of $20,000 per month of benefit, so our employees earning up to $400,000 are fully protected.”
I thought about his response for a moment, and then asked, “So, if I earn $250,000 of base salary and $150,000 in bonuses for a combined total of $400,000, I would be protected at 60 percent. Correct?”
He thought about my question and answered, “No, actually, only base salary is covered under our group disability plan.”
His response further solidified what I’ve discovered after talking with a number of companies. And that is the disturbing fact that, for many companies, its group disability coverage only provides 60 percent of base salary, with no protection for bonus income. This means that many employees have significantly less coverage than they think.
Let’s look at a hypothetical example. The vice president of sales for a consumer products company makes $400,000 per year, which includes a base salary of $250,000 and a bonus of $150,000. He is suddenly hospitalized for complications from diabetes and he goes out on long-term disability. It’s his belief that his monthly disability income will be $20,000 per month ($400,000 x 60% divided by 12 months). Think of his surprise when a monthly check shows up in the amount of $12,500 ($250,000 x 60% divided by 12).
In this case, the key question that employees need to get answered is: “60 percent of what?”
- Is it 60 percent of base salary?
- Is it 60 percent of base salary, plus the annual bonus?
- Is it 60 percent of base salary, plus annual bonus and long-term bonus?
- Are the benefits taxable or tax free?
- What is the monthly benefit cap? Is it $15,000, $20,000, $25,000 or $30,000?
There are many different ways benefits are calculated, so this can be both complex and confusing. Some employees are covered at 60 percent of compensation, while others are actually covered for as little as 20–30 percent of their net takehome pay after taxes.
Let’s look at another scenario.
Bob is the vice president of development at a software company, earning a $250,000 annual salary and $150,000 bonus. Bob suffers a stroke. The company’s group plan provides 60 percent of annual salary and the benefit is taxable. His original pre-disability, after-tax take-home pay was $21,667 per month, or $260,000 per year ($250,000 + $150,000 – 35% tax). Now his disability after-tax benefit is $8,125 ($12,500 – 35% tax) or $97,500 annually. Bob must now live on 37.5 percent of his pre-disability take home pay.
Fortunately, there are supplemental disability insurance products available to solve the problem, and they can either be firm-paid or voluntary. In the case of law firms, consulting firms and investment firms, there are other issues to face. In these types of businesses, it’s not uncommon for partners to earn well in excess of one million per year, with most benefits already structured as tax-free. For these companies, the biggest problem is the benefit cap, which is usually $25,000 to $40,000 per month. This is either group-only or a combination with traditional individual supplemental coverage.
Let’s look at another case study. John is a law firm partner, earning $1.2 million a year. He has multiple sclerosis and goes out on disability indefinitely. He has $35,000 per month of coverage (a group LTD policy of $25,000 and supplemental coverage of $10,000). This means his original pre-disability, after tax take home pay of $780,000 ($1.2 million – 35% tax) is now $420,000 ($35,000 per month). Now that he is disabled, he must now live on 46 percent less after tax income. Again, not a pleasant situation once you’ve established a certain lifestyle. But there are ways to avoid this happening.
The London insurance market, specifically Lloyd’s of London, has been proactively involved with developing specialty insurance products for over 300 years. About ten years ago, Lloyd’s recognized the opportunity to develop multi-life supplemental disability insurance coverage for the U.S. market to protect highly compensated employees that are otherwise limited by the benefit cap instilled by U.S. disability insurers. Now, highly compensated employees can obtain the additional coverage they need to more adequately protect their income. In John’s case, with this additional coverage, he would receive an additional $25,000 per month from Lloyds’ for a total combined benefit of $60,000 per month ($720,000 per year), representing a 60 percent income replacement (group LTD $25,000 + traditional supplemental $10,000 and Lloyds’ coverage at $25,000).
This new coverage has created a lot of confusion, however. The problem is that people are starting to refer to Lloyd’s disability products generically, like Kleenex tissue, when, in fact, Lloyd’s of London is actually a marketplace that consists of over 50 separate underwriters writing insurance coverage on Lloyd’s paper with 85 different syndicates sharing the risk. The result is that now there are several different products, some of which are dramatically more comprehensive than others.
Employers should review their disability programs to understand what limitations currently exist. Equally important, employers should make it a priority to learn about the supplemental products and strategies available to fill the gaps in coverage, so that they are able to select the structure and definition of disability that best meets their firm’s needs.