Corporate Disability Buy-Ups
Getting More Coverage for Less for Highly Compensated Employees
Being unable to work for medical reasons is one of the greatest financial threats workers can face. CPAs, CFOs and in-house financial managers need to know what types of disability protection and what insurance programs are available that an employer can use to offer greater benefits to highly compensated employees. This article explains how CPAs can help employers negotiate group disability buy-up policies that offer executives more monthly income-replacement coverage tax-free and at less cost to the company.
GROUP INCOME-REPLACEMENT PLANSMost workers who have disability insurance acquire it through group plans established by their employers. Such plans are tax-favored under the Internal Revenue Code which provides that group premiums are deductible by the employer and nontaxable to the employee. Group disability-insurance plans are the fundamental insurance building block for all workers. However, highly compensated employees feel the hidden limitations of this coverage most acutely.
All carriers have set limits on the percentage of employees’ income they will insure. Generally, the maximum percentage insurable is 60% of total compensation. The rationale for this limit is that insurers consider higher percentages of coverage a disincentive to return to work. The percentage of insurance coverage decreases as compensation increases. For example, coverage for someone earning $50,000 annually yields a $2,500 monthly benefit (60% of monthly income). However, coverage for someone with an annual income of $100,000 provides a maximum $4,167 monthly benefit (50% of monthly income).
Insurers also put a cap on the maximum monthly benefit under the group plan. In most cases the top monthly benefit is $10,000; in some cases it is $15,000 and only rarely $20,000 or above. The maximum benefit amount insurers will issue is based on factors such as the size of the group, the type of industry, the geographic location and the aggressiveness of the particular carrier. Nonetheless, maximum monthly benefits, when combined with the percentage limits discussed above, further curtail payments to highly compensated employees. For example, an executive earning $300,000 annually faces a maximum benefit of $10,000 per month (only 40% of compensation).
GROUP SUPPLEMENTAL APPROACHThe rise in compensation over the last decade, combined with the acknowledgement that the highest paid employees are the least insured, has prompted a number of insurers to develop group disability supplemental plans, popularly known as disability buy-ups.
Before delving into the details of buy-up plans, however, more discussion about compensation is in order. How any group disability plan defines compensation is a matter of negotiation between the group and the insurance company. The most restrictive definition explains compensation as salary (in a corporate environment, this means W-2 income) excluding overtime and bonuses. The most liberal definition equates compensation with all of the cash payments the highly compensated individual receives (including pension and profit-sharing contributions).
TYPES OF BUY–UPSCPAs will find these plans come in several different shapes and sizes.
- The employer-paid plan. When employers pay the premiums on buy-up plans, those premiums are tax-deductible as an "ordinary and necessary business expense." While the premium payment is not considered as taxable income to the employee, the employee does have to pay tax on any disability benefits received. Employer costs are the primary constraint with this type of plan.
- The employer-sponsored plan. This is the most popular approach. The employer merely acts as the plan sponsor, allowing the insurance company to directly solicit employees. The employees pay the premiums. If employees pay those premiums with post-tax dollars, the employees do not pay any tax on any benefits received. If the employer has an IRC section 125 plan in place, the employees pay the premiums with pre-tax dollars and any benefits received are taxable. Because employees own these disability policies, the policies stay with the employees if they change jobs. One large carrier waives participation requirements for the first year; it will guarantee to issue policies irrespective of the percentage of eligible employees who elect coverage. This is one of the few fringe benefits employers can provide without a cash outlay.
- The hybrid plan. The employer pays the premiums for a select group of employees. Those premiums are tax-deductible to the employer, however any benefits received by those covered employees are taxable to the employee. Other employees can purchase policies on a voluntary basis with their own funds. Any benefits they receive are not considered taxable as the employees paid the premiums with post-tax dollars.
COMMON ELEMENTSHere’s what CPAs need to know about how buy-up plans operate.
Plans are two-tiered. The first tier is a guaranteed issue policy—the carrier asks no medical questions and is obligated to issue a policy at standard rates. The second tier requires some simple medical questions: Are you presently at work? Have you been hospitalized in the last year?. With second-tier plans, the carrier may decline to issue the policy, charge extra premiums or partially restrict coverage, perhaps excluding coverage for something such as a spinal injury. The guaranteed-issue coverage will help the employer solve any problems with executives who have medical problems.
The eligible group is always limited to the highly compensated. Clearly, the larger the group, the more significance this holds. A buy-up policy targets those in need of a higher percentage of coverage and excludes, by definition, lower-paid workers. Despite continuing concerns among carriers about overinsurance, the competitive realities of the market have brought a significant change in insurance company outlook, thereby offering the highly compensated a new opportunity to increase coverage.
Underwriting requirements are negotiable. Because this is a lucrative market for insurance companies, competition is fierce. Employers can and should negotiate the number of persons in the group, the amount of benefits in both tiers and the definitions of compensation and disability, along with premium rates. Buy-up policies generally are individually owned. In other words, the employee can continue coverage after his or her employment ends by continuing to pay the premium. That is not the case with the underlying group coverage.
Returning to the executive earning $300,000 a year who is entitled to only a $10,000 monthly benefit under the company’s group plan, here’s how a typical buy-up plan might work.
Most carriers will discount the underlying group coverage of $10,000 by 25% (or 35%) as a marketing strategy to garner more business. Because of discounting, the executive is now deemed to have only a $7,500 monthly benefit from that plan. The company offers and issues a first-tier (guaranteed-issue) monthly benefit amount of $2,500. It also issues a second-tier benefit (nonguaranteed, but simplified underwriting) of $2,500. The result is a $15,000 monthly benefit ($10,000 base group, $2,500 first tier, $2,500 second tier) or 60% of covered compensation instead of only 40%.
WHAT’S NEXT?CPAs need to look at several additional factors when helping clients and employers evaluate disability buy-up plans.
- In situations where the employer pays for the buy-up, the key issue is the availability of cash to pay premiums, presumably for the long-term. Failure to make premium payments means coverage for the top executives ends--a group not likely to be happy when it hears their employer no longer is paying for these benefits.
- CPAs/CFOs need to evaluate the company’s current base group disability-insurance coverage to see whether it can increase maximum benefits. If so, the employer must determine what the cost will be for lower-paid vs. highly compensated employees. As a result of the two limits discussed earlier, the increases in coverage that buy-up policies provide go only to higher paid staff members.
- CPAs should consider asking the insurance companies bidding on the group buy-up coverage to quote the employer’s base group disability coverage as well. This may make the prospective buy-up carriers more liberal in amounts of coverage, compensation definitions and guaranteed issue amounts while at the same time putting the current base group carrier on notice that it needs to be competitive in its pricing and coverage.
- CPAs should help the employer analyze the "company census" to determine who might be eligible for the buy-up and to make sure the plan fits into the current benefits package offered to highly compensated executives.
Stanley B. Siegel, JD, is president of HR&S Financial, a Philadelphia-based financial services company offering insurance and personal financial planning services. His e-mail address is .