A simple framework for other income & long term disability

The topic of deducting other sources of income from long term disability benefits recently came up through our work with ACORD. A seemingly straightforward question was raised: “if an individual is receiving LTD benefits from a carrier, then what happens if they also receive money from somewhere else?”. This turns out to be a confusing topic for many. The jargon, legalese, and calculations found in an LTD policy have a way of leaving even the most experienced advisers with their head in their hands. If you’re an employee benefits professional who’s struggled to explain “Other Income” to a client before, then this post is for you. WatchTower has developed a three question framework to simplify the topic, and help you advise your clients.

First, a quick primer. In the group disability insurance industry, it’s commonplace for carriers to reduce a claimant’s payments when they receive income from other sources (think worker’s comp, social security, or retirement system benefits). This may feel like a sleight of hand trick at first. A carrier promises to make payments, but then reduces them when other forms of income become available. The fundamental purpose of disability insurance is to replace a portion of an individual’s income when they’re no longer able to earn one themselves.

What’s important to understand is the spirit of that agreement is to provide financial support as long as the individual is not receiving more money than they were before they stopped working. If you exceed that threshold, then you remove the incentive for the individual to return to work. The practice of reducing disability benefits by other sources of income is designed to avoid that outcome. It helps to keep rates affordable, and aligns the motivations of the insurance carrier, claimant, and employer.

So, how does this all work? The clearest way to think about “other income” is to break it into three questions:

1. What types of income are considered deductible?

2. What is the formula used to deduct them?

3. Does the deduction apply to income received by employees and dependents?

The rest of this post expands on these questions in greater detail. Here we go.

1. What types of income are considered deductible?

Lots, is the short answer. It’s less important to memorize every type, and more important to understand them categorically. For the sake of simplicity you can bucket them as follows:

Income received under occupational law

  • e.g. workers’ compensation, unemployment benefits, occupational disease

Income received from government or employer sponsored retirement/disability plans

  • e.g retirement/pension plans, social security, state disability, or another group disability plan

Income received from sick leave, salary continuation, severance, or subrogation (third party settlement)

A caveat to acknowledge is that the above does not reference income earned by working part time for the employer. Income earned by returning to work on a part time basis is highly encouraged by carriers, and treated more favorably through a provision called the “partial disability formula”. Because this is a meaty topic in of itself we’ll save it for another post.

It’s easy to assume the other types of income listed above are defined identically from one carrier to the next, but that is of course not the case. For example, a “gotcha” moment to be aware of lives in the third category. Some policies reduce benefits for salary continuation and accumulated sick leave. Some reduce for one but not the other. And some reduce for neither. Moreover, the timing of the reduction and the calculation itself can vary. Often, this language can be customized by the carrier if you take the time to communicate with them.

This point should be underscored. It’s been famously said that that the enemy of communication is the illusion that it exists. This is true, personally and professionally, and is the mindset necessary to build healthy adviser/carrier relationships. Translating the employer’s needs into carrier-speak prior to writing a piece of business will ensure the policy is written correctly, and differentiate you as an adviser.

2. What is the formula used to deduct them?

There are two formulas used more than any other: Direct and All Sources.

Direct — With this method, the LTD benefit is reduced dollar-for-dollar by all of the “other income”. It’s simple, easy to understand, and the most cost-effective approach. An estimated 95%+ of disability policies are written with this formula. The insured receives:

  • Basic monthly earnings x Benefit % (e.g. 60%) — deductible sources of income

All Sources — With this method, two different calculations are compared to determine the benefit amount. The insured receives the lesser of:

  • Basic monthly earnings x Benefit % (e.g. 60%)
  • Basic monthly earnings X Higher Benefit % (e.g. 70%) — deductible sources of income

The All Sources method generally provides a larger benefit to higher wage earners (those otherwise capped by the max benefit), and for lower paid employees that are receiving other sources of income. As a result it’s a load to the LTD rates, but can be a material impact at claim time.

3. Does the deduction apply to income received by employees and dependents?

There are two answers to this question: Yes or No.

Family — If the answer is “yes”, then it’s referred to as family integration. This means any income an employee, spouse, or child is entitled to receive as a result of the disabling event will reduce the LTD benefit.

Primary — If the answer is “no”, then it’s referred to as primary integration. This means that only income an employee is entitled to receive will reduce the LTD benefit.

Logically, most types of “other income” are paid to the employee, and not to a spouse or child. However, an exception is Social Security Disability (SSDI). The SSDI program pays benefits to disabled workers, and to their spouses or children (whether or not disabled).

A policy with family integration will reduce the disability benefit by the employee and dependent’s portion of the award. Whereas a policy with primary integration will reduce the disability benefit by only the employee’s portion. For reference, in 2014 the average monthly SSDI award for an employee was $1,146, whereas the average award for an employee with spouse and child was $1,943. The delta between those numbers ($797) is the average impact this provision has on the take home pay of an employee in need.

While it requires effort to dig in to contractual nuances like these, the ounce of prevention will be worth it. As a starting point, we hope you can make use of this three question framework in your own business. Anchoring yourself to a mental model will provide clarity of concept for yourself and the client. The details can always be looked up or confirmed with your carrier partner. Of course, don’t hesitate to reach out to the ThreeFlow team if you need a hand. We’re here to help!

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