10 Shortcomings of Group Long Term Disability Insurance
Updated: Aug 8, 2023
This article outlines how group Long Term Disability insurance (LTD) often falls short of individual income protection needs. Group LTD can be characterized as "basic" coverage for the masses, meaning that it is not designed to provide a lot of individual financial security and choice. Employers rightly seek to avoid subsidizing people not to work and instead value uniformity and cost control because they are in the business of widget-making, not financial planning. But that leaves some people - especially those higher up on the income scale - with gaps.
Disadvantages of Group Long Term Disability Insurance (LTD)
Meeting the definition of disabled may depend on whether it is possible to work differently.
It's not enough, once the nature of disability is understood.
Formulaic adjustments cause some people to get less.
The benefit is reduced by certain other sources.
The benefit may be taxable.
Coverage may be lost or reduced as a result of flexible work, even if the underlying reason is to deal with a health issue.
Coverage may be lost due to employment changes.
With each new employer, a new Pre-Existing Condition Limitation period applies.
Special limitations apply to certain types of claims.
ERISA applies, which makes it harder to prevail in a contested claim.
Let's flesh these points out with more detail.
1. The definition of disability generally allows the insurer latitude to account for how the job could be performed differently before deeming the worker disabled. This may factor in reasonable accommodations, technology assistance and consideration for how the occupation is generally performed in the national economy.
When the claim is two (2) years old or so, an additional hurdle arises. The definition of disability will then typically transition to an "any occupation" test, which considers ability to work in any other occupation. At that point, the insurer will have much more room to be creative and terminate a claim.
Group coverage does not typically have a "true" own occupation definition of disability, which is the gold standard in the industry and is relatively common in individual markets. Group coverage monitors a claimant's earnings so that claimants cannot end-run the financial hardships by moonlighting in another occupation. Some professional groups such as law firms may have specialty-specific language, which does help for purposes of qualifying as disabled, but doesn't help to get living standards up.
2. It's not enough, once the nature of disability is understood. A standard group LTD benefit is 60%, which may sound okay when it's all theoretical, but when things get real the absolute minimum suddenly becomes 102%. Some of this has to do with reluctance to reduce lifestyle, especially with a family to support, or failure to downsize quickly enough when there is so much uncertainty. One thing that is certain is that at some point employee benefits will have to be replaced.
Medical insurance premiums need to be funded by the individual without employer financial support. The loss of the employer's medical insurance subsidy is worth - very roughly - about $2,000 per month counting deductibles, depending on the plan and family size. This would constitute an increase in household overhead.
Retirement contributions stop during a period of disability, which is a real financial loss that will hit later. What will replace these?
The burden on loved ones is important to account for, not just emotionally but also financially because if a working spouse is pulled away from their own career to pick up the slack at home or help out with health care needs, that will compound the financial loss at the household level. If disability is severe enough to require care or supervision (i.e., long term care), even 100% income replacement may not be enough.
3. Formulaic adjustments cause some people to get less. Once an insurer agrees that disability exists, the natural response is "Great! How much is my benefit?" This is not a simple question. Group disability benefits are calculated based on a formula, and the hard part is determining what pre-disability earnings to apply the percentage against.
The formula begins with filtering out all forms of compensation other than what is defined in the policy, which is normally base pay only. Bonus pay, commissions, and other incentive pay are usually excluded for a variety of reasons, including the additional load to pricing, poor risk spreading, and the additional complications that stem from infrequency of payment. Small business owners that take significant portions of compensation in non-salary form may find this especially limiting for their own personal income protection purposes unless special arrangements are made.
There is also an absolute cap on the group LTD benefits, the most common of which is $10,000 per month. At that level, anyone earning more than $200,000 per year is "capped out." After these adjustments are made, it is not unusual for highly compensated employees, production staff, and owners to receive only 25% income replacement.
Even rank and file employees can be affected because the formula is based on a percentage of earnings immediately prior to disability, which may be lower than normal. An untimely dip in earnings can happen for many reasons, including a health problem. When illness happens, employees who take reduced earnings without going on claim risk a permanently reduced benefit if health later declines to the point where a claim is justified. People dealing with chronic conditions are the most susceptible, because performance tends to reduce gradually.
4. Offsets for certain other sources reduce the benefit. That 60% benefit includes Social Security and other government benefits. There may be additional offsets for third party recoveries, which makes legal action pointless. Other common offsets include PIP auto coverage, distributions from employer funded retirement plans, pension disability benefits, severance pay, and of course, work earnings. The effect is to reduce the insurer's claims expenses and apply sufficient financial hardship to induce a person to return to work.
5. Taxes are usually withheld from the group benefit. This one is the least universal. Broadly speaking, only one side of the cash flow can be tax advantaged. Most employers choose to take their tax advantage on the front end (when the premium is paid) because it is certain and immediate, knowing that any future benefits will be taxable to employees. Employers structure their programs this way in order to avoid the additional load on the premium and minimize current taxes to the business, especially as it concerns payroll taxes.
6. Eligibility may be lost just before it's needed. When faced with a health problem, employees often choose to "power through" by taking a reduced workload instead of taking leave. They often deny the option to claim disabled status. The problem is that group disability coverage has a minimum hours requirement. Therefore if the employee attempts to power through by taking reduced hours without filing a claim, there may be no coverage when it's needed, if the health situation continues to deteriorate.
Even if the minimum hours can be maintained, the fact that benefits are based on a percentage of earnings immediately prior to disability means that any reduction in earnings will result in a smaller disability benefit if a claim is later filed. Working less, even with temporary intent, is like shooting oneself in the foot.
In theory, these problems shouldn't happen as a result of the very thing being insured against. But in practice, employees are not very careful about documenting cause and effect, and harm their own case by claiming that they were not disabled early on.
7. Dependence on an employer makes it less reliable. Many things can trigger a loss of eligibility, including voluntary departure or as part of a reduction in force.
8. Pre-existing conditions are typically excluded during a person's first year of employment, and this needs to be re-satisfied with each new employer. There is no credit for prior disability coverage at another employer, which is different than medical insurance. For workers that regularly job hop and have long bench times, such as CFO's, it is not uncommon to have deficient coverage most of the time.
9. Special limitations on how long benefits last may apply to certain types of claims. Typically, the special limitation is twenty-four (24) months, which cuts short claims that otherwise may have gone to age 67 or so.
Nearly universal in group LTD insurance is the limit on psychological and substance claims, often referred to as the mental-nervous limitation or the "psych limit." Exactly what counts as a psychological condition is typically determined by the most current version of the Diagnostic and Statistical Manual of Mental Disorders (the DSM), which is encompassing enough to make the psych limit surprisingly relevant even for people who have no relevant history. DSM-listed conditions can enter the picture downstream of treating conditions even of non-psychological origin, say, as the result of a botched operation or as a side effect of prescribed pharmaceuticals. Questions can arise over whether disability is more closely attributed to the underlying malady or the psychological effects that followed, complicating the claim and providing the insurer with an out.
Some group policies apply a special limitation for environmental, musculoskeletal and self-reported subjective claims such as pain. With regard to pain, only pain from sources not observable with medical scanning is the focus. But still, unexplained pain can come from anywhere; and because it would be hard to treat, is more prone to being "long term."
10. The Employee Retirement Income and Security Act (ERISA) puts employees at a disadvantage in the event of a claims dispute. Although ERISA was intended to protect employees, is has been turned on its head when it comes to disability. ERISA is disadvantageous for workers due to (a) the higher burden of proof, (b) limited room to pivot a case, (c) an obligation to exhaust other remedies first, and (d) there is no possibility of punitive damages in ERISA cases, which means the insurer has little to lose by putting up roadblocks. So they do.
"That's Just What's On Offer"
There isn't a lot employers can do. With the possible exception of tax treatment, employers would expend great effort and expense to please a small number of astute employees. Even the most paternalistic employer would have a hard time bolstering the protection aspects of LTD because many of the barriers are inherent to group policy ownership, regulatory requirements, and risk spreading. Risk spreading relies not only on uniformity, but on keeping the nature of the claims easy to manage.
Even if improvements can be made, they will likely be short-lived. That's because there is constant pressure to keep compensation costs down and it is quite easy to communicate how much money will be saved, whereas it will be difficult to remember why certain quality improvements were made years ago, especially with HR and CFO turnover.
Employers are usually fairly aware of the gaps above, but that's just what's on offer. Employees should take the same attitude and accept LTD for what it is - "basic" paycheck protection. It forms an important foundation to build on. For employers and individuals that value to protection aspects of disability insurance, a completely different type of disability insurance should be in place at the same time, paying over and above what group LTD provides.
The Role of Individual Disability Income Insurance (DI)
Individual disability insurance can supplement group coverage and pay claims separately, which has the effect of raising total income replacement and diversifying benefit sources. Known as individual Disability Income (DI) insurance, this kind of insurance is characterized by stronger guarantees and features, and costs considerably more than group LTD. Individual policies are probably best known for the non-cancellable "true" own-occupation variety, which is the gold standard among highly paid workers.
DI allows individuals to control their own destiny and resist being managed back to work by having sufficient resources to sit out. Properly designed, it can also allow a person to return to work with far higher economic security.
In short, DI is the solution to the shortcomings listed above.
How Group and Individual Disability Insurance Compare
Let's look at a side-by-side comparison of group Long Term Disability and individual Disability Income insurance.
Group Long Term Disability Insurance (LTD) characteristics
Individual Disability Income Insurance (DI) characteristics
Eligibility must be met continuously (e.g., 30 hours per week) or else coverage is lost
Qualification is done only once, to acquire the policy, afterwards no employer or hours requirement applies.
Benefit must be calculated based on a formula (e.g., 60% of base salary up to a cap, minus other sources)
Benefit is based on a pre-determined fixed dollar amount (e.g., $10,000 per month)
Optimized for getting employees back to work and low cost
Optimized for individual financial security and choice; stronger guarantees and features
Premiums are based on a composite rate based on group demographics and may be experience rated; premiums are not guaranteed
Premiums are based on individual risk factors and there is no experience rating; premiums are often guaranteed not to go up until age 65
ERISA is typically written into the policy
ERISA is typically not written into the policy
The fundamental difference is that with individual coverage, the policy is fixed in both ownership and benefit amount, thereby permitting far more security and choice. That individual DI is a standalone policy has downstream implications for policy design which permit much stronger protection features in many respects.
It is important to appreciate both types for what they are. LTD's basic nature makes it possible for employees to have something in place with maximum convenience and minimum cost. Notwithstanding the gaps discussed here, LTD plays an enormously positive role in the financial well-being of workers who will not seek out, qualify for, or pay for anything else.
In short, LTD provides a valuable foundation, but for people with good jobs and a big nut to crack every month, it probably shouldn't be relied upon as the only source of income protection.