Disability Insurance Aimed at Retirement

A handful of insurers have begun selling a new kind of disability insurance targeting employers with pension and 401(k) plans. Known as retirement disability insurance, it seeks to protect the nest egg of a disabled worker, and it may prove a valuable addition to employee benefits packages.

However, it’s unclear what the Internal Revenue Service thinks of this insurance, so before you buy it, get the advice of expert tax counsel.

In essence, retirement disability insurance follows a simple idea: Pension and 401(k) plans allow people to defer taxes on earned income. Because disabled workers earn no income, they can’t shelter it in pension or 401(k) plans, with perhaps serious results at retirement age.

The disability insurance seeks to guarantee that the nest egg of the disabled worker continues to grow no matter what. The policies work with defined-contribution pension and 401(k) plans, although not under all circumstances, and they don’t work with defined-benefit pension plans.

At present, three major insurers--UnumProvident, Union Central Life Insurance and Massachusetts Mutual Life Insurance--sell the coverage, but they don’t address a wide market. If the insurance proves popular, however, you can bet that other insurers will enter the marketplace.

To see how the insurance works, consider the plight of the totally disabled worker.

Disability income insurance replaces the income of the disabled person for a specific period--sometimes two years, sometimes five years, sometimes until age 65. The idea, of course, is to keep body and soul together until the worker begins receiving Social Security benefits.

*

These days, however, Social Security alone won’t keep body and soul together for long. Studies show that baby boomers expect Social Security to meet only a quarter to a third of their income needs at retirement, with the difference coming from their pension and 401(k) plans, along with other savings.

But illness or injury can leave you unable to work and therefore ineligible for contributions to your pension or 401(k). The result: You may face old age with no nest egg to supplement Social Security.

The shortfall can be substantial. A 35-year-old who salts away $10,000 a year in a 401(k) plan has $1.2 million at age 65, assuming investment earnings of 10% a year. If the employer matches the contribution with $2,000 annually, the nest egg reaches nearly $2 million, again assuming a 10% return.

A nest egg of $1.2 million gets the retiree $72,000 a year, assuming interest at 6%; $2 million brings in $120,000. It’s real money, and without it, the disabled retiree may enter old age in want.

The three retirement disability insurance policies on the market address this problem in different ways.

The UnumProvident policy works with profit-sharing plans and defined-contribution pension and 401(k) plans. It pays a benefit equal to the employee’s contribution plus the employer’s, if any, to a maximum of $30,000 a year. The benefits go into the employer’s pension or 401(k) plan just like ordinary contributions.

It is not clear, however, how the IRS regards the flow of dollars; at present, UnumProvident awaits a ruling from the IRS on two important questions: whether the benefits avoid current taxation like ordinary contributions do, and whether disabled employees must pay income taxes on a portion of the benefits, as all employees do on some forms of group term life insurance.

*

Company officials expect the IRS to rule favorably on the first question but perhaps not on the second. The upside is that even if the IRS does not rule favorably on the second question, the income taxes would in all likelihood be minimal.

The UnumProvident policy has a fairly liberal definition of disability--the key element in any disability insurance policy. You receive a benefit for up to two years if the disability renders you unable to perform the duties of your own occupation. You receive benefits thereafter if the disability prevents you from engaging in any occupation for which you are reasonably qualified by training and experience, until age 65.

Union Central sells its plan primarily as an additional benefit for employers with 401(k) plans set up and administered by Union Central itself--which is to say, the insurer does not aggressively market it to other employers.

Like UnumProvident, Union Central pays a benefit equal to the total contribution to the plan--that is, the employee’s contribution plus the employer’s match--up to a maximum of $20,000 a year, payable until age 65. The insurer uses the same liberal definition of disability in this coverage as it does in its group long-term disability coverage: You are disabled if you cannot perform the duties of your own occupation.

Mass Mutual, concerned about the tax questions that prompted UnumProvident to seek the IRS ruling, takes a different tack with its policy.

Benefits max out at $30,000 per year, invested not in the employer’s pension or 401(k) plan but in mutual funds via a trust established by BankBoston. At age 65, the disabled employee receives income from the trust just like he or she would from the employer’s pension or 401(k).

The Mass Mutual definition of disability is fairly liberal: You are disabled if you cannot perform the main duties of your occupation and you aren’t working in another occupation. Mass Mutual sells the insurance as group coverage to employers or separately to individuals.

Given the focused marketing efforts of these three insurers, the coverage isn’t selling like hot cakes. But if other insurers see the opportunity, they too will begin offering it, no doubt broadening its applicability even as they broaden the market.

Premiums for the insurance aren’t exorbitant, given the benefits. They do, of course, vary with the risk of the group.

*

Juan Hovey can be reached at (805) 492-7909 or at jhovey@gte.net.