Long-Term Disability: Forgotten Risk to Retirement Income
Drains on retirement income abound. That’s natural in the course of daily life. But one of them — long-term disability — is largely unheralded, despite its being less than rare, argues a recent analysis.
In “Addressing the Risk of Long-Term Disability on Retirement Income
,” an article appearing in the Journal of Pension Planning & Compliance
, David Kaleda, Emily See and Matt Schoen argue that long-term disability is a “hidden threat” to millions of workers’ retirement security. The root of the problem, they suggest, is the rise and prevalence of defined contribution plans. “Many workers and employers alike are unaware of the danger disability can pose to participants of DC plans such as 401(k)s,” they write.
Disability is “shockingly common,” the authors argue, and they cite statistics that state that approximately 13% of U.S. workers will be disabled for five or more years during their time in the workforce, and that 90% of them will experience that due to chronic conditions or illness. And that won’t be getting any better, according to Social Security Administration statistics they cite which say that 25% of those who are age 20 now will become disabled before they are retirement age.
And the threat disability poses is heightened by the shift from DB to DC plans, the authors argue. This, they say, is because DB plans usually continued to accrue benefits for disabled employees, but DC plans generally do not do so. Not only that, they observe, employees contend with all of the investment risk entailed in 401(k)s.
Not to mention the possibility of needing to withdraw money from a retirement account to help with a major expenditure such as a home purchase, college tuition or bills related to a disability. “A long-term disability has the potential to leave a worker with little or no retirement savings at all,” they write.
Even more ominous, the authors warn, is that most employers “have not adequately addressed this issue.” They attribute this in part to federal regulations not making it possible to do so. But that, at least, has changed.
“Fortunately,” they write, “recent regulatory changes have made it possible for long-term disability insurance to cover retirement plan contributions.” They cite regulations the IRS and Treasury released in 2014 that they say “cleared a path to protect retirement contributions directly within DC retirement plans, including 401(k) plans.” They add, “Under the new regulations, disability insurance covering plan contributions is considered a plan investment, therefore, crucially, premiums and benefit payments are not taxable to the participant (i.e., until withdrawn at retirement).”
There is a way for an employer to address the challenge that long-term disability poses to employees’ finances during retirement that complies with the regulations, they say: providing coverage directly within the DC plan, as long as it is structured correctly.
But the authors include an important caveat: “It is essential to note that these regulatory changes alone do not solve the problem of the gap in disability coverage; rather, they only make it possible for employers to finally address this coverage gap in a manner integrated with the retirement plan.”
“The new IRS regulations are only the first step in mitigating the effects of long-term disability on retirement savings,” they write, noting that there are two other approaches employers can take: They can self-insure by amending their 401(k)plan to say the employer will continue contributing to disabled employees’ retirement plans, or they can buy coverage outside of the DC plan.
“The onus is now on employers to determine which approach best balances their needs with those of their employees,” they conclude.