This article offers insight into the relationship between disability and early retirement, reviews sources of longer-term disability coverage, and provides ideas about how employee benefits can enhance financial security during retirement.

Disability is not well understood: Faces and key statistics

Disability can have a devastating effect on workers and their families.

Depending on the structure of benefits, long-term disability (LTD) may mean loss of earnings, no further retirement savings, high health costs, and the need for family to care for the disabled individuals.

Consider a few facts:

One in eight workers will be disabled for five years or more before they retire. One in four of today’s 20-year-olds will be disabled before they retire, according to the Council for Disability Awareness, 2013.

Sixty-nine percent of workers in the private sector have no private LTD insurance, also according to the Council for Disability Awareness, 2013.

90 percent of Americans underestimate their chances of disability, and 85 percent express little concern that they will suffer a disability lasting three months or more.

Disability and emerging patterns of retirement

DC plans are unlike DB plans since they do not have built-in incentives for people to retire at a particular time. With more people retiring later, there is a need to examine how disability benefits link to emerging retirement patterns.

Current employer-sponsored disability programs are designed primarily for people who retire all at once and do not specifically recognize people who retire from one occupation and later work in another.

Fitting disability security with emerging work and retirement patterns is an issue for public policy-makers, insurers, employers, and advisors.

A commonly proposed solution for people who have inadequate retirement savings is to work longer.

A number of actuaries and other pension professionals talk about the need to increase retirement ages as people live longer, but disability benefits need to be adjusted in order for this to work well overall.

Longer periods of work make the topic of disability and retirement benefits more important.

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Disability and retirement security: DC disability benefit design questions

In DC plans, the employer and/or the participant make contributions to an individual account on behalf of the participant, who bears the investment and longevity risk. Contributions are typically based on compensation.

The total benefit available to the participant at retirement (or some other permitted distribution event) is based on their account balance, which consists of employer and participant contributions and any investment gains.

Logically, it makes sense to offer the equivalent of a waiver of premium provision and include continued savings in the DC plan, but this is not usual practice.

Such a provision parallels the use of continued benefit accrual in a DB plan, but does not parallel other methods historically used for treating disability within DB plans. This issue is much more important when the DC plan is the primary retirement vehicle.

Any period of time when a participant cannot continue contributions to their account balance has an impact on their savings at retirement. An employee who is disabled from ages 50 to 55 will lose five years of retirement savings (and the investment earnings thereon) that they will usually not be able to recover over the remaining working career.

There are a number of questions to be asked if a DC plan is to add a disability benefit, such as these:

• Will we cover both employer and employee contributions?

• Who will pay for the benefit?

• If the cost is shared, what approach will achieve the best overall outcomes?

• If contributory, how often are contributions adjusted?

• If the benefit is voluntary, how do we deal with anti-selection?

• How best can we manage the risk and/or insure the benefit?

There are also questions to be resolved to administer the benefit:

• Will elections be handled as part of the annual enrollment? If not, how?

• How do we collect contributions if contributory?

• Are claim determinations made together with LTD claim determinations?

• Will all covered people also have LTD? If not, what do we need to do to manage this program?

• How do we transfer claim funds to the 401(k) record-keeper so they are correctly allocated to participants’ accounts?

Legal and tax issues also need to be resolved. Here are some examples of conceptual approaches that can be used to make up lost savings:

Continue employer contributions during disability period. This seems analogous to a waiver of premium provision in life insurance.

Implement alternative savings option outside of DC plan. The employer purchases additional LTD insurance (i.e., current income replacement insurance) on behalf of its employees. Upon the occurrence of a disability and the subsequent triggering of payments under the LTD policy, the proceeds from this additional coverage are invested on behalf of the participant in an annuity or IRA. The proceeds of the investment supplement the retirement benefit otherwise accumulated under the DC plan.

Purchase “LTD 401(k) Insurance” as an investment in the DC plan. The participant elects to have a portion of their own (and possibly employer’s) contributions to purchase LTD coverage offered as an investment option under the plan. Insurance is funded either through a LTD policy or a voluntary employee benefits association (VEBA) established on behalf of one or more employers. In the event of disability, the insurance carrier pays cash to the participant’s account in the amount of the contributions they (and possibly their employer) were making prior to disability.

From an actuarial and risk management perspective, each of these approaches can work to support continued accumulation of funds for retirement, but none was trouble free in the regulatory environment in 2012. [ERISA Advisory Council, 2013]

Further research is needed in the evolving legal environment. Individuals can also solve the problem through the purchase of individual insurance to replace retirement contributions. In any case, care is still needed to see that funds are not withdrawn early.

What employers can do today to enhance security in a DC world

It is important to find ways to increase employee participation rates in LTD benefits and capitalize on the advantages of auto-enrollment in the LTD plan.

Employees without LTD coverage will likely tap into their retirement savings if they are disabled. This is an issue for employers, insurers, and public policymakers.

Employers and employees need a greater awareness of the issues surrounding disability and the catastrophic nature of LTD, including the impact on retirement income.

There is also a need to help people who are disabled continue to save for retirement for themselves, since using retirement funds at time of disability risks leaving no assets for future retirement. This is a potential problem with plans that pay a lump sum at time of disability.

It is important for employers providing retirement security through DC plans to focus on these issues and think beyond the DC plan for risk protection. Ideally, plan sponsors will provide more employee-friendly direct disability benefits integrated within DC plans, such as these:

• Disability insurance as an investment option in the 401(k) or outside of the plan.

• A generous after-tax group LTD program, and encourage employees to make contributions to a tax qualified plan and an IRA up to the applicable limits. Use auto-enrollment to increase participation.

• A voluntary disability program to purchase added coverage on an individual basis to make up retirement savings.

• Communicating the importance of not dipping into retirement savings during disability. Help employees understand the need to plan for disability.

• Exploring creative ways to share costs with employees that might drive good participation and enhance retirement readiness if the program is partly employee paid.

• Helping disabled employees get rehabilitated and return to the workforce. Offer good job options to such employees.

At the same time, financial planners can do the following:

• Educate clients about disability risk including retirement savings not continuing during disability.

• Help clients secure adequate disability coverage. Review employer-sponsored coverage and generally encourage enrollment in such coverage. Help them capitalize on one-time opportunities during job or benefits change, and alert them to the importance of focusing on benefits offered without evidence of insurability only at initial enrollment.

• Supplement employer-sponsored coverage with individual coverage. Select reliable insurance carriers.

• Evaluate whether riders to protect retirement savings and those that offer inflation protection are needed.