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Protecting Your Retirement Plan Against Disability: Insurance Options Make Contributions When You Can’t

If you’ve given serious thought to your personal financial plan, you probably have considered how a long-term disability could impact your financial security. Various studies put the chances of an individual becoming disabled at some point during a working career at anywhere from 30% to 50%. In fact, working adults are more likely to become disabled than they are to die. 1

Perhaps you’ve heeded such statistics, and are covered under a disability income plan at work. Perhaps you’ve even supplemented that plan with an individual policy. Even if you’ve taken these important steps, chances are that, in the event of a disability, these policies may replace 60%-70% of your pre-disability earnings. This sum may cover your living expenses, but is unlikely to be sufficient to allow you to save for retirement or any other future need.  Furthermore, most disability income policies end payouts at age 65 or your normal Social Security retirement age.

The importance of making regular contributions to a retirement plan or IRA has grown in recent years. Gone are the days of widespread coverage under a traditional pension plan, funded by an employer and paying a guaranteed income for life. Though some individuals are still covered under a traditional pension plan, one is more likely to participate in a defined contribution plan, such as a profit sharing or 401(k) plan. These plans typically rely heavily on employee contributions in order to build up a sizable account balance.

Where will you find the income to continue to make retirement plan contributions in the event of a disability? Failing to make retirement plan contributions can have a dramatic impact on the accumulated nestegg at retirement age. For example, an individual who, at age 40, begins to contribute $500 each month to a retirement plan will have built a nestegg of almost $350,000 at age 65 (assuming a return of 6% and not taking taxes or inflation into account). What if that individual becomes disabled at age 55 and cannot afford to continue to make contributions for the remaining ten years until retirement? Even if the plan balance remains untouched until age 65, their retirement nestegg will be significantly smaller: only a little more than $260,000. The difference is even more dramatic at higher contribution levels. Even a year or two of missed contributions can reduce the nestegg, especially if they occur early in one’s career.

Some disability insurance carriers have developed products specifically designed to provide retirement plan contributions. Known under various product names (depending on the carrier), such retirement income protection plans are not pension plans: they are disability policies that pay, as the benefit, an amount that approximates what the disabled insured would have been contributing to a 401(k), profit-sharing, or other type of retirement plan, had he or she been able to work. The goal under such policies is to provide the insured with the retirement income that would have been expected if the disability had not occurred.

The benefit typically is based on the average contribution the insured had been making to a retirement plan, up to a maximum as set by the policy (usually based on the retirement plan contribution limits set by federal law). The benefit also may include an amount for any contribution the employer normally would make. The benefit is deposited into a trust product at a financial institution. Investment decisions are typically made by the insured. At retirement age, the accumulated assets are distributed to the insured to supplement whatever is received from their original retirement plan.

Policy specifics will vary carrier to carrier. Riders may be available that adjust the benefit amount for inflation or for income increases that would have been expected, if not for the disability. As with any disability product, the prospective insured should pay close attention to how disability is defined, for example, whether benefits eligibility is determined by the inability to work in the insured’s regular occupation, or any occupation.

The nestegg we build for retirement comes as a result of hard work and discipline. It makes sense to protect that nestegg, just as we protect other important assets, such as our lives and homes. Retirement income protection recognizes the importance of saving for retirement, and gives insureds the security of knowing they’ll be able to continue to do so, even if faced with a disability.

1 Source: Society of Actuaries 1985, CIDA Table.



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