Disability Insurance Explained

Insurance, Life Insurance
Disability Insurance Explained

One of your most valuable assets may not be among the first things that come to mind when you think about your finances. It’s not your house, car or retirement account. It’s your ability to make a living.

Disability insurance pays a portion of your income if you can’t work for an extended period because of an illness or injury.

Here’s what you need to know:

Why you need disability insurance

Disability insurance is important because most people don’t have the emergency savings to keep them afloat for even a short period without a paycheck.

A 2015 study by the Pew Charitable Trusts found that 55% of American households can replace less than a month of their income through liquid savings — money that’s readily available.

“Everybody who relies on a paycheck should have this coverage,” says Keith Hoffman, vice president of disability insurance at NFP Corp., an insurance brokerage and consultancy headquartered in New York.

Yet 69% of Americans don’t have disability insurance, according to Northwestern Mutual’s 2016 Planning & Progress Study. The chance of a long-term employment absence from a disabling injury or illness may seem remote, especially if you’re young and healthy and work at a desk job.

“You never think it’s going to be you,” says Carol Harnett, president of the Council for Disability Awareness, an insurance industry group.

But more than one in four 20-year-olds will experience a disability for 90 days or more sometime before they retire, according to the Social Security Administration. The average length of a long-term disability claim is almost three years, according to the council.

Accidents aren’t the primary cause of disability. Back injuries, cancer, heart attacks, diabetes and other illnesses lead to most disability claims, the council says.

One of the reasons people shrug off the risk of disability is that they think about worst-case scenarios, such as spinal cord injuries leading to quadriplegia or horrific accidents that result in amputation, Harnett says. Those instances are indeed rare. But disability insurance also provides coverage for extended illnesses and more commonplace injuries — think weekend warrior mishaps — that can keep you out of work for weeks or months. A short-term disability policy can also pay a portion of income for recovery after childbirth or for pregnancy complications — if the doctor orders bed rest, for instance.

“The questions people have to ask are, ‘What would you do if you couldn’t work? How far could you go without a paycheck?” Harnett says.

Types of disability insurance

There are two main types of disability insurance:

  • Short-term disability insurance replaces a portion of your base salary, usually 60% to 70%, up to a monthly dollar cap under employer-sponsored plans, for a specified period. It usually pays out for less than six months but could last up to a year after an illness, injury or childbirth. There may be a waiting period of up to two weeks after you become disabled before the benefits kick in.
  • Long-term disability insurance replaces a portion of your base salary, usually 40% to 60%, up to a monthly dollar cap, such as $10,000. The benefits end when the disability ends. If you remain disabled, benefits may end after a specified number of years or last until you reach retirement age, depending on the policy. Some policies also provide payment for additional services, such as training to help you get back into the workforce after a disability. A long-term disability insurance plan also has a waiting period. The length varies by policy, but a common period is 90 days. The waiting period is typically timed so the benefits kick in when the short-term disability insurance ends.

Disability policies vary in how they define “disabled.” Some policies pay out only if you can’t work any job for which you are qualified. Others pay out if you can’t perform a job in your occupation. Some policies cover partial disability, which means they pay a portion of the benefit if you can work part time. Others pay out only if you are fully disabled and can’t work at all.

How to get disability insurance

Here are ways to get covered:

  • Sign up for employer-sponsored coverage at work. Most employers that offer disability benefits pay some or all of the premiums. Five states require employers to provide short-term disability benefits, according to the Society for Human Resource Management: California, Hawaii, New Jersey, New York and Rhode Island.
  • Purchase disability insurance through your workplace. Some employers don’t pay for disability coverage but offer it as a “voluntary” benefit, giving employees the opportunity to buy coverage through the employer’s insurance broker at a group rate.
  • Buy disability insurance through a professional association. Many professional groups offer members coverage at group rates.
  • Buy an individual disability insurance plan. You can purchase disability insurance from an insurance broker or directly from an insurance company. Big sellers of individual disability insurance include Guardian, MassMutual, Northwestern Mutual and Principal Financial Group. Most individual disability policies sold are for long-term coverage, although some insurance companies also offer short-term policies.

Buying your own disability policy

Consider buying your own policy if you don’t have any or enough disability coverage at work or if you’re self-employed. Employer-sponsored disability insurance usually pays only a portion of your base salary, up to a cap. It’s a good idea to supplement that coverage if you earn a high salary that far exceeds the cap or if you depend on bonuses or commissions.

An insurer will consider your other sources of disability insurance to determine how much insurance you can buy. Generally, you can’t replace more than 75% of your income from all the coverage combined, Hoffman says.

Buying your own coverage has several advantages. It lets you:

  • Customize the coverage with extra features, such as annual cost-of-living adjustments to benefits.
  • Choose the insurance company with the best offerings.
  • Take the coverage with you when you change jobs. Employer-paid coverage ends when you leave the company. (You might be able to take coverage with you if you pay the full premium for disability insurance offered through the workplace.)
  • Control the disability insurance. You keep the coverage as long as you pay the premiums. Employer-sponsored coverage will end if the employer decides to stop providing disability benefits.
  • Collect benefits tax-free if you become disabled. If your employer pays the premium, you must pay taxes on any benefits you receive.

Premiums for a long-term disability insurance policy generally range from 1% to 3% of your annual income, according to the Council for Disability Awareness. However, a variety of factors will affect the cost of an individual disability insurance policy, including:

  • Your age and health: You’ll pay more the older you are and the more health problems you have.
  • Your gender: Women usually pay more because they tend to file more claims.
  • Whether you smoke: You pay less if you don’t smoke.
  • Your occupation: You’ll pay more if you work in a job with a high risk for injuries.
  • The definition of disability: The broader the definition of disability, the higher the premium. A policy that covers you if you can’t work in your own occupation but could earn income in a lower-paying job will cost more than a policy that covers you only if you can’t work at all.
  • Length of waiting period: This is known as the elimination period. You can reduce the premium by increasing the waiting period before benefits kick in.
  • Your income: The more income you have to protect, the more you’ll pay for coverage.
  • Length of benefits: The longer the policy promises to pay out if you become disabled, the more you’ll pay in premiums.
  • Extra features: Additional features, such as cost-of-living adjustments to protect against inflation, will increase the premium.

Who offers individual disability insurance

The following companies offer disability insurance to individuals.


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Ameritas


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Colonial Life


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DIonDemand


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Guardian Life


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Illinois Mutual


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MassMutual


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MetLife


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Mutual of Omaha


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Northwestern Mutual


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Ohio National Financial Services


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Principal


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The Standard


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State Farm


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Sun Life Financial

When you’re thinking about buying long-term disability insurance, Hoffman suggests asking yourself these questions:

4 questions to ask yourself

QuestionTip
How much of your income would you need to replace to maintain your lifestyle if you became disabled and couldn't work?Use the answer to determine the monthly benefit to select.
How long could you wait before the disability benefits kicked in?This will determine the "elimination period" — the number of months you would wait after becoming disabled for the policy to pay out. A typical elimination period is 90 days, but you can choose shorter or longer periods. The longer the elimination period, the lower the insurance price.
How long would you want the benefits to last?For some occupations, such as plumbers and carpenters, benefits are limited to five years on most policies, Hoffman says. For desk jobs, you can choose a benefit period to last a certain number of years or up to a certain age, such as 65. The longer the benefit period, the higher the price of the policy.
How broadly would you define "disability?"Highly skilled people who have invested a lot of money in training may want a policy that pays out if they can't work in their specialty. A neurosurgeon who loses the ability to operate might still be able to teach or work as a general practitioner, for instance, but those positions would pay far less than a career as a surgeon. Another consideration: Do you want a policy that pays out a portion of the benefits if you are partially disabled, meaning you can work only part time? Hoffman recommends this option because people who suffer a disability often need to cut back on their hours, either on the front end as their condition deteriorates from an illness or on the back end as they recover from an injury or illness.

To cut the cost of a policy, Hoffman recommends increasing the waiting period before benefits kick in, then looking at reducing the payout period. As a last resort, he says, look at reducing the monthly benefit amount below what you think you’d need to get by.

Comparing employer-sponsored and individual disability insurance

Employer-Paid Disability InsuranceIndividual Disability Insurance
Easy to qualifyCoverage is portable (moves with you to new jobs)
Premiums are no or low cost to youBenefits can be customized to fit your needs
Insurance payouts are taxableChoice of insurance companies

Other ways to find disability protection

The following programs also offer financial protection in case of a disability, but they have limitations.

  • Social Security pays disability benefits, but it’s difficult and time-consuming to qualify, and the payments are low. The average monthly disability benefit in 2015 was $1,165.
  • State disability programs are offered in California, Hawaii, New Jersey, New York and Rhode Island. They provide short-term disability coverage, in most cases for up to six months, according to Life Happens, an insurance industry trade group.
  • Workers compensation insurance replaces some of your income if you’re disabled because of a work-related injury. All states require employers to have workers compensation coverage for their employees, but most long-term disabilities are not the result of work-related injuries.

Although these programs can help if you qualify after a disability, they don’t fully cover the risks of losing your ability to work after an illness or injury. Disability insurance is the smart bet to provide a safety net.

Barbara Marquand is a staff writer at NerdWallet, a personal finance website. Email: bmarquand@nerdwallet.com. Twitter:@barbaramarquand.

This post was updated on June 27, 2016.