In any discussion of employee disability benefits -- including those with highly compensated employees and professionals, a lack of understanding becomes quickly apparent. Whether it's an office assistant 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% coverage. In other words, if they become disabled, they will receive 60% of their annual compensation. Starting with their first job out of college, they always seem to remember something about disability insurance at 60%.
As it turns out, the 60% figure is an illusion. Unfortunately, employees only come face-to-face with reality when they have become disabled and delve deeper into the actual coverage.
The crucial question, every employee should ask is this: 60% of what? The answer is more complex than one might either expect or be prepared for:
o Is it 60% of the base salary?
o Is it 60% of the base salary, plus the annual bonus?
o Is it 60% of the base salary, plus annual bonus and long-term bonus?
o Is it cash compensation only? What about deferred compensation, restricted stock or other compensation?
o Are the benefits taxable or tax-free?
o What is the monthly benefit cap? Is it $10,000, $15,000, $20,000 or $25,000?
o What is the definition of disability? Is it an inability to perform your own occupation for two years or to age 65? Is it partial disability or total disability only?
What first appears to be a simple, direct and clear question turns out to be complex and even confusing.
The vast majority of all employer group disability insurance plans cover 60% of base salary with a maximum monthly benefit cap of $10,000 to $15,000. There are few companies that cover base salary and annual bonus up to $20,000 per month. Employer-paid benefits are taxable at the time of claim, while employee-paid benefits are tax-free.
The dramatic differences that occur between plans covering just base pay and others that include bonus compensation are obvious. Some benefits are taxable with others being tax-free. The maximum monthly benefit cap restricts them all.
Talk about an illusion: Some employees are covered at 60% of compensation, while others are actually covered at only 10%-15% of their net take-home pay after taxes. Here are actual examples:
Scenario I
The vice president of a manufacturing company with a $200,000 annual salary and a $100,000 bonus becomes disabled from a head injury resulting from a car accident. The company's group plan will provide 60% coverage but only for base salary. There is also a maximum monthly benefit of $10,000 on the plan and the benefit paid is taxable.
His original pre-disability, after tax, take-home pay was $16,250 per month or $195,000 annually ($200,000 + $100,000 - [35% tax]). Now that he is disabled, his monthly after-tax benefit is $6,500 ($10,000 - [35% tax]) or $78,000 per year. He must now live on 40% of what he was taking home before the disability occurred.
Law firms and investment firms are unique and suffer from their own problems. Most already have their plans structured to provide tax-free benefits. Yet, their biggest problem is the benefits cap. Even though the partners of major law firms and money management professionals frequently earn $1 million to $3 million a year, their disability benefits are still capped at $25,000, $30,000 or $35,000 per month. It's not surprising that many of these highly compensated professionals honestly believe they are protected at 60% of their earnings, when, in fact, the actual figure is far less. Unfortunately, due to the financial exposure of large claims, it isn't practical to increase the group disability benefit.
There is supplemental disability insurance available to solve the problem, either firm-paid or voluntary. However, the first step is to recognize that there may be a serious problem.
Scenario II
The partner in a large law firm earns $1 million a year, has a brain tumor and goes out on disability, indefinitely. He assumes his group disability plan will pay 60% of $1 million tax-free (60% = $600,000). Unfortunately, while the firm's disability coverage will pay 60% of earnings, there is a maximum benefit cap of $30,000 per month, which equals only $360,000 per year.
This means his original pre-disability, after tax, take-home pay of $650,000 ($1 million - [35% tax]) is now $360,000. He is now faced with living on 45% less, after tax, than he was before becoming disabled.
Having just come through one the most stressful financial periods in the past 60 years, can you imagine how difficult it would be if you suffered an accident or an illness and could not continue to work? Eighty-five percent of all disabilities are illness-related, such as cancer, multiple sclerosis, diabetes and heart disease. Combine that with the occasional auto accident or head injury and the picture is devastating. Then add in a disability insurance plan that doesn't protect 60% of earnings and the picture becomes unusually grim.
Employers should review their programs to determine how best to solve this problem, whether it is with a company-paid or a voluntary program. The employees should be educated on the limitations of their current disability program, as well as the strategies that are available to fill the gaps.
Everyone's most important asset is his or her income and it deserves the best possible protection. The biggest and most tragic mistake is thinking you will have 60% of your income should you become disabled.
Gary F. Terry is executive vice president and managing director of The Westport Group and has more than 28 years of corporate planning expertise associated with executive benefits. He is one of the developers of Executive Income Assurance, a proprietary disability income plan designed to protect highly compensated executives, both domestic and foreign. A graduate of the Northeastern University School of Business, he is an alumnus of Norwich University where he is a member of the Board of Trustees. He can be contacted at (781)380-1010 or gterry@westportgp.com.
