How to Minimize Disability Risk for High-Income Earners
Seventy-seven percent of workers think that missing work for at least three months because of injury or illness would cause a financial hardship, while half think it would cause a “great hardship.”
Nearly all households, ninety percent, say that they would suffer financial hardship if they were disabled and unable to work for a year.* For this reason, disability insurance remains a long-standing core employee benefit.
Most companies provide their employees with a group long-term disability plan (LTD) that typically covers a percentage of their salary, typically 60 percent. Income Replacement Benefits are paid in the event of a sickness or injury resulting in a disability while employed.
For low to middle-income employees who derive most their compensation from a base salary, LTD can be an effective tool to ensure they can meet their financial obligations in the event of a disability.
By contrast, high-income earners, such as corporate executives, professionals and business owners, often have more sophisticated compensation packages that can include benefits like bonuses, partnership distributions, retirement contributions and restricted stock units. For these individuals, suffering a disability could lead to significant income shortfalls.
Four Types of Non-Salary Compensation
Different forms of non-salary compensation for high-income earners are:
Annual Bonuses
According to human resources consulting firm Aon Hewitt, the percentage of total payroll dedicated to performance-based annual bonuses has increased since the economic downturn of 2008.
Aon Hewitt concludes that companies have become more comfortable with pay-for- performance, as well as limiting their exposure to fixed salary expense in the event of another recession.
This compensation trend presents two challenges to high-income earners regards most LTD programs: 1) often, the base salary of these employees exceeds the maximum coverage amount; 2) bonuses, commission and other incentive payments are not covered.
As an example, ABC Company offers a group LTD plan that covers 60 percent of salary up to a benefit of $15,000 a month. If John Smith of ABC earns an annual salary of $300,000 and an annual bonus of $180,000 (total compensation of $40,000 per month), he is limited to 37.5 percent coverage ($15,000/$40,000), as opposed to 60 percent for lower-earning employees.
Partnership Distributions
Law firms commonly use partnership structures. Equity partners of a law firm are entitled to a share of the company profits, in addition to earning a salary and other employee benefits.
While some law firms adjust their LTD plan to include higher monthly benefit caps to accommodate high-earning partners, exposure still exists in the event of a disability.
To illustrate this problem, let’s examine a mid-size, California-based law firm with 20 partners and total earnings (salary plus partnership distributions) between $500,000 and $800,000 annually. The firm maintains an LTD plan that provides a 60 percent benefit up to a maximum $20,000 monthly benefit; that is, partners earning up to $400,000 realize full coverage. However, LTD plan will only cover between 30-48 percent of the total compensation of the 20 high-earning partners.
Retirement Plan Contributions
A recent Retirement Plan Survey conducted by Aon Hewitt shows nearly 70 percent of employers report that 401(k) plans are the primary retirement vehicle they offer to their employees.
This study confirms the trend of the last 30 years─namely; employees must fund most of their retirement. Highly compensated employees face the additional burden of limitations to how much they can save in 401(k) plans, as well as the amount of benefit they will receive at retirement from Social Security.
In the event of a disability, an employee not only misses the opportunity to defer his income into a 401(k) plan, he also does not receive any match offered by the employer. Depending on the beginning age and length of the disability, this limitation could have a significant impact on future retirement plans for high-income earners.
RSUs involve a promise by the employer to grant restricted stock at a specified point in the future. RSUs became a prevalent form of compensation in the early 2000s when changes in accounting rules lessened the advantages of offering stock options to employees.
A review of publicly traded company proxy statements reveals that the amount of RSUs paid out to executives can often be three to five times annual compensation. This pay out creates a substantial challenge for highly compensated employees in the event of a disability. To understand the potential magnitude of the problem, let’s review the details of the compensation plan of Mary Miller of XYZ Company.
- Annual Salary of $750,000 with an annual bonus of $250,000;
- RSUs of $2,000,000 with 50% vesting at three years and the remainder vesting after four years;
- Total compensation is $3,000,000; after-tax income (35% rate) is $1,950,000.
Mary’s monthly income, in the event of a disability, would be $30,000 ($20,000 from LTD and $10,000 from individual coverage) meaning she would receive only slightly less than 20 percent of her current after-tax income.
Supplemental Solutions to Consider
As evidenced above, the different forms and magnitude of compensation earned by successful individuals can present a serious gap problem in the event of a long-term disability.
When looking to solve the potential income shortfall, a highly-compensated individual should consult an insurance professional with a thorough understanding of supplemental coverage.
Supplemental coverage options can range from individual disability insurance policies, which can address the needs of those with bonus and other forms of incentive compensation to specialty products that cover those with significant partnership distributions, as well as restricted stock units.
*Source: Consumer Federation of America and Unum, “Employee Knowledge and Attitudes About Employer-provided Disability Insurance,” Opinion Research Corporation Survey, April 2012.
If you would like more information on how to address the disability risk of high-income earners, you may contact Don Curristan, Managing Director at EBS. Voice: 760.788.1321 Cell: 619.318.6620 or e-mail to dcurristan@ebs-west.com.