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10 Shortcomings of Group Long Term Disability Insurance

If you have group Long Term Disability insurance (LTD), you see it as a defense of your living standards in case your income stops due to a health problem. But from your employer's point of view, group LTD is not really designed to provide individual financial security or choice. Instead, group LTD's core purpose is to take pressure off the payroll when there is no choice, and get you back to work as soon as possible.

Unfortunately for workers with satisfying careers and substantial earnings on the line, financial security and choice are significant issues. To assist individuals and financial planners in determining whether group LTD is good enough, refer to this rundown of considerations and see if they apply to the group policy you are reviewing.

  1. Meeting the definition of disabled may depend on whether it is possible to work differently.

  2. It's not enough, especially after new expenses are accounted for.

  3. Formulaic adjustments cause the benefit to be less than 60%

  4. The benefit is reduced by certain other sources.

  5. The benefit may be taxable.

  6. Coverage may be lost or reduced as a result of flexible work.

  7. Coverage may be lost due to employment changes.

  8. With each new employer, a new Pre-Existing Condition Limitation period applies.

  9. Special limitations apply to certain types of claims.

  10. 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, the definition of disability will then typically broaden 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%. Reducing lifestyle is not as easy it seems because the largest financial commitments are fixed and as long there is hope for recovery, no disrupting changes are likely to be made. Reducing lifestyle is especially difficult with a family to support.

One financial surprise relates to medical insurance premiums. When the employee is no longer actively at work due to disability, they lose eligibility for the employer's medical insurance subsidy and have to pay the COBRA premiums individually. They don't necessarily lose the health insurance itself; rather, they lose the subsidy, and this constitutes a new financial burden.

Don't forget, upon disability, medical insurance premiums are funded by the individual through COBRA, without employer financial support. That's about a $2,000 per month increase in personal expenses counting deductibles and out-of-pocket costs, depending on the plan and family size.

Retirement contributions stop during a period of disability, which is a real financial loss that will hit later, especially if there was any employer contribution such as 401(k) match. What will replace these?

A working spouse doesn't help when you account for what else is happening at the household level. The spouse is pulled away from their own career to pick up the slack at home, which will either compound the financial loss at the household level or cause incredible stress. If disability is severe, it may be necessary to hire help for care or supervision (i.e., long term care). If that happens, 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.

The formula begins with filtering out forms of compensation other than what is defined in the policy. Bonus pay, commissions, and other incentive pay are usually excluded because the infrequency of payment complicates the volume tracking and for most months isn't present when disability begins (among other reasons). Small business owners that take significant portions of compensation in non-salary form (e.g., S-corporation ownership distributions, K-1 earnings) don't get what they need personally unless special arrangements are made.

There is also an absolute cap on the group LTD benefits such as $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.

Everyone, including rank and file employees, can be affected because the LTD formula is based on a percentage of earnings immediately prior to disability, which may be lower than normal due to a health problem that gradually reduces performance and job responsibilities, and reduces earnings in turn. Taking any reduced earnings without going on claim is a huge risk because if health continues to decline to the point where a claim is made, the benefit will be lower. 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 compels a disabled person to participate in legal proceedings that will result in no personal benefit whatsoever. 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 of all these offsets is to reduce the insurer's claims expenses and, of course, to apply sufficient financial hardship to induce a person back 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.

graph illustrating reduction in LTD benefits due to formulaic adjustments

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 hours instead of going on disability claim. The problem is that group disability coverage has a minimum hours requirement for eligibility, so the well-meaning and hard working employee ends up cutting themselves out just when the need is coming into view.

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 proportionately smaller disability benefit if a claim is later filed.

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. The upshot is that group LTD has structural impediments to choice and security.

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. 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.

When enhancements are made, they tend to be short-lived. That's because it is difficult to remember why certain quality improvements were made years ago, especially with HR turnover. But the cost savings are definable.

Seasoned benefits professionals have a good defense: "that's just what's on offer." A more realistic improvement would be for employees to build on it individually.

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, in particular the non-cancellable "true" own-occupation variety, which locks in the terms of coverage and allows for moonlighting in a different occupation without being penalized.

DI allows individuals to control their own destiny. Properly designed, it can also allow a person to return to work with far greater economic security. In short, DI is the most practical solution to group LTD's shortcomings.

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

Group policy, owned by the business

Individual policy, owned by the insured individual

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 until the end of the guarantee period (typically to age 65)

Benefit must be calculated based on a formula (e.g., 60% of base salary up to a cap, minus other sources)

Benefit is a pre-determined fixed dollar amount (e.g., $10,000 per month) or based on loss of income

Optimized for getting employees back to work

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

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.

But for people with good jobs and a big nut to crack every month, group LTD probably shouldn't be relied upon as the only source of income protection.


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