Disability Insurance - Is this an E&O Risk to Financial Advisors?

by Ronald I. “Woody” Woodmansee, CLU, CEBS, MSFS

Many years ago, I wrote an extensive article for PEPC with much of the detailed contractual features and language around both group and individual disability insurance (“DI”) contracts. Although that article (Fall 2003), and the details in it, are still very relevant, I think it is time to take a step back and educate fellow financial advisors (“FA”) on the need for a thorough review of disability coverage for their clients. Being an “old school” insurance-only expert, with no securities license, and who does no “financial planning,” I am passionate about this topic, especially having specialized in this area for over 43 years.

I will take it a step further and throw it out that, in my humble opinion, not looking at these details for a client puts an FA at risk of being accused of, and even being sued for, malpractice. If an FA is to oversee a client’s overall planning for taxes, retirement, investments, estate planning etc., how can one overlook the largest source of funds for most clients, their income?

The truth is that FAs come in all varieties: they come from insurance backgrounds, investment backgrounds, those that do not come from either of those backgrounds, and everything in between. Although there is no right or wrong way to develop an FA, because of their expertise, experience and sometimes even their likes and dislikes, many turn a blind eye, or stick their heads in the sand, when it comes to planning.

Two recent examples prove my point: I was giving a talk on this topic for a local insurance/planning agency several months ago. After the meeting, the firm leader confided in me that disability sales, and life insurance sales too, in the organization are down, even among the veterans who had written much of this coverage in the past. He went on to say that many of the associates in the office have become more “comfortable” with the revenue stream provided by the AUM (assets under management) approach to the business.

A few weeks ago, I received a phone call from a friend, an FA who focuses mostly on retirement planning. Although most of his clients are older and no longer have big DI needs, he had a young client who actually asked the FA about this protection. In his call to me, the FA admitted that he was comfortable with getting some “cheap” term life insurance for the client, which he did. He also admitted that he was way over his head on DI, which is why he called me. This young client now has a very solid individual DI policy in force, after having also reviewed in detail the options his employer offered.

Why do FAs not get into detailed DI planning? Perhaps one of many reasons: simple oversight, lack of knowledge or expertise, fear of losing a client after the “challenging” underwriting process and less than desired outcome, false assumption of no need because most large employers provide some group Long Term Disability (“LTD”), no real expert to whom to turn for help, etc.  After all, unless a client is from familial wealth, his or her biggest asset is the lifetime income he/she may earn, which is usually, among our high-net-worth clients, in the $2 to $10 million range.  We insure our $70,000 vehicles, we insure our teeth for up to $1,500/year, we sometimes even insure our $800 phones, yet taking care of the golden goose is many times an afterthought at best.

Let’s look at some real-life situations. Your client is an executive at XYZ Company and makes a $250,000 annual salary and has been paid a $100,000 bonus in each of the last three years. The employer-paid group LTD has a maximum benefit of $10,000/month, a very typical group LTD max.

In this scenario, his or her after-tax take home pay is about $13,500/month, give or take (assuming 65% of gross income), not counting the bonus, and not adding back in retirement savings or medical insurance premiums, etc. The $10,000 group LTD plan max is BEFORE tax. Because the employer pays for it, which is usually the case, the benefits paid to him/her are taxable at claim time, a fact that most ignore. Now, if we assume just a 25% tax rate on the LTD benefits (which I use for simplicity and because most DI carriers also use that rate in calculating how much additional after-tax/tax-free coverage they will issue), the after-tax group LTD benefit is $7,500/month.

As a result, this executive is now replacing $7,500/month of his/her current $13,500/month take-home pay, which is just 55% of his/her after-tax take home pay.  Said another way, the individual has a loss of 45% of current take home pay!!

Even if the salary was lower, or the LTD benefit max was higher, the result is always the same. Because of the taxation of employer group LTD benefits, there is almost always at least a ⅓ reduction in take home pay, a simple fact that very few recognize. In employee benefit communication meetings, when talking about the LTD plan, I always rhetorically ask how many in the room do not need all of their take home pay? There are always a few good chuckles by those who are alert (at least for the moment anyway).

The reality is that one of two things happen with everyone’s take home pay: it is spent or saved. There are no other options or use for that money and many Americans spend the majority of their take home pay, and many spend even more than that.  If the income earner does not have appropriate coverage at the time of disability, the FA then needs to rework the client’s budget to see what items will now be forgone.

Now let’s add the bonus to the mix. The $100,000 bonus equates to another $5,416/month of after-tax income (100,000/12 X .75). When added to the $13,500 above take-home pay on the base salary, the new average take home pay is $18,816/month. So, the new after-tax replacement is 39% ($7,500 / $18,916) of take-home pay (not gross pay)! I see income reduction amounts like this all the time; the higher the income and bigger the bonus or other comp, the worse it gets.

Most group LTD plans only cover base salary (plus commissions, usually) but not bonuses. Even with those few group LTD plans that cover bonuses, there are employees (your clients) that are impacted by the group LTD plan max. A $10,000 per month group LTD max is very common, and a $15,000 max is also fairly common. But, even with that higher $15,000 max, ANY income over $300,000 is not covered at all. If this client had additional outside consulting income (think university professors, etc.), that additional income could also be covered by a supplemental individual DI policy, as the basic employer group plan does not cover it.

In general, carriers that write individual supplemental DI policies will issue up to 65% of total after-tax earnings with a limit of up to $30,000/month or more of supplemental individual coverage. Some carriers now also will participate in conjunction with group LTD coverage of up to $40,000/month in the standard marketplace (group and individual coverage combined). In fact, some carriers issue more total individual coverage in conjunction with group LTD than they will with no group LTD inforce. Additionally, there is also a limited market for even more coverage through some traditional market carriers as well as Lloyd’s of London and others for the ultra-high-income earners.

Let’s now talk about a small business owner situation, which is much different than the executive scenario described above. This can apply to a professional practice (medicine, law, medicine, engineering, accounting), a consulting firm, a startup company, a closely held business, or any firm that is relatively small (two to 50 employes).

Good quality individual policies are expensive, though once issued, the rates and contracts are guaranteed until age 65. For that reason, where there is forethought and flexibility available, it may well be advisable to put in place a combination of inexpensive group LTD along with more robust individual policies on top.

• Group LTD plans can be issued with just two full time employees (after the company has been operational for at least a year)

• Plans are very cost-effective (less than $100/month total cost for a group of up to five employees)

• Group plans cover everyone, while still leaving the option to cover executives, owners, etc. with tailored supplemental individual policy benefits.

This is a clear win-win in giving a valuable baseline benefit to everyone and then amplifying the coverage for key employees.

I once wrote such a combo plan years ago because an agent from a major life insurance company told the CFO that there were no group LTD options at the five-employee level (maybe he wanted the higher comp by selling just higher cost individual DI policies?). A potential downside to this combo approach versus just using all individual policies is that the contractual features of group LTD contracts are far inferior to those of good individual policies, such as the definition of total disability, portability, rate guarantees, additional features, etc.

I came across a situation many years ago with a client where the Board of Directors was requiring the CEO to purchase an individual DI policy benefit of $5,000 per month to cover his $100,000 compensation.  As an alternative, I suggested an inexpensive group disability policy for all 12 of his employees with a maximum benefit of $3,000 per month, plus a supplemental contract for $2,000 - $3,000 per month for himself.  I told him that the combined cost of those two products would be cheaper than the cost of one larger individual contract.  His response was “prove it to me.”  I did and we immediately put that combo program in place.

Just a little contract advice here, also to perhaps avoid a potential E & O claim. On all supplemental DI policies, I always, always, always recommend a future purchase guarantee. Sometimes due to age or underwriting rigors it is not offered. This option guarantees the ability to increase coverage as one’s income increases, REGARDLESS of any health changes.  Increase options are generally available every year or every other year and through age 55 or 60, depending on the carrier. Since very few people get healthier as they age, this option is crucial, especially for younger clients with high income and/or self-employment potential. Clients may receive options to purchase up to $15,000/month or more in the future, guaranteed, with NO additional medical underwriting (just financial/income justification). Also do not forget the importance of the future purchase guarantee option due to job and benefit changes, potential future self-employment, and other such life and career changes.

(There also are built-in but minimal automatic benefit increase riders in most contracts, although they typically only increase coverage with small inflation adjustments [3-5%] and don’t handle large income increases.)

A classic case showing the value of this option is a situation where someone who gets hit in the back in a car accident or develops another condition (heart, cancer, etc.).  That person may not be disabled, but now may not get a contract issued or a benefit increase without an exclusion because the back is now considered a pre-existing condition.  If this person had the future purchase guarantee, he or she could increase the coverage as the income increases with no exclusion for the back problem, as long as the person is not actually disabled, and was still working full time for the prior 90 days.  I did such a guaranteed increase a few years ago on a physician client who, although still working, has just been diagnosed with cancer.

Although the focus is sometimes only on replacing as much of our client’s income as we possibly can during working years, most of us forget about what happens to our retirement savings if we are unable to contribute to retirement plans during a prolonged period of disability. 

The average 401(k) balance in the United States today for baby boomers, according to Fidelity Investments website, is somewhere around $250,000. Imagine what happens if one is not able to save for retirement.  People sometimes think that if they are disabled until age 65 (or at 67, the new Social Security Normal Retirement Age (“SSNRA”)) there is going to be some magical pot of money that will just appear from Social Security.  If you believe that, I will be happy to sell you some swamp land in Florida.

Because of this, there are now options in the marketplace offering policies or riders that continue savings in a retirement plan during disability.  These benefits are paid in addition to any individual or group DI in-force coverage.  In most cases these plans can cover not just employee salary deferral amounts into a 401(k) or other retirement plan, but also any employer provided matching contribution and/or profit-sharing contribution.  In some cases, this could be as much as $40,000 or more per year. 

Another unheralded fact is that it is possible to have these benefits pass tax-free to an account that will grow tax deferred.  This helps to establish a much higher cost basis for the benefits to be received at retirement, unlike a pre-tax (non-ROTH) qualified plan that has zero cost basis, making everything taxable at retirement.  This concept has a lot of merit and is virtually untapped in the marketplace. Truth be told, although I have owned this option forever, I too have not sold enough of it to my clients.

There are now also policy options that similarly cover student loan debt as part of the income benefit. These are very inexpensive and are geared towards younger clients that still have student loan debt (e.g., physicians, attorneys, etc.)

In summary, if you as an FA have not yet looked at the adequacy of DI for your clients, perhaps it is time to do so, for your and your clients’ benefit. If you are not qualified or simply not comfortable in doing so personally, seek out and partner with a qualified insurance professional who can help. It only takes one disgruntled client or ex-client, or his/her attorney, to make your life miserable. After all, none of us can know everything and half of knowledge is knowing where to get the answers. Doing so is just another example of the benefits of cooperation and collaboration that PEPC seeks to promote … and perhaps avoid a potential E & O situation in the process.

Ronald I. “Woody” Woodmansee, CLU, CEBS, MSFS, is the owner of Woodmansee & Co., Inc., a Marlton, NJ based employee benefit and insurance firm.  He is a graduate of the Wharton School of the University of Pennsylvania and has been practicing in the Philadelphia area for more than 40 years.  He can be reached via e-mail at Woody@woodmanseeandco.com.