How Much Income Replacement Is Enough?

Along with the definition of disability and elimination period, after-tax income replacement has a big impact on the cost of a disability plan. It’s important to get the right income replacement ratio for the group. So what’s the right ratio?

Shoot for 55% to 70%

For most groups, aiming to provide disabled employees an after-tax benefit equal to between 55% and 70% of their predisability earnings is a good target. Providing a benefit in this range is good for a number of reasons:

• It gives most eligible employees a sufficient benefit to keep their financial house in order until they can return to earning their full income.
• It's not so generous that it serves as a disincentive to return to work.
• It's not so low that it puts an employer at a disadvantage when it comes to recruiting or retaining talent.

Don't Forget Taxability

Remember, the key is after-tax income replacement, and who pays the premium has a big effect on that. If the employer is paying the premiums with pre-tax dollars, benefits will be taxable. If the employer grosses-up the premiums or if the employees pay the premiums, benefits will be tax-free. Be sure to take this into account when determining income replacement.

Pricing Rules

Your goal should be to provide reasonable income replacement while minimizing cost. Remember these basic pricing rules when determining income replacement and who pays the premiums:

• 2 for 1 Income Replacement Rule — A 1% increase in income replacement typically means a 2% increase in plan costs; 1% is due to the increase in the monthly benefit and 1% is due to longer claim durations.
• 5% Paycheck Rule — When premiums are visibly taken out of employees paychecks, claim incidence will increase a minimum of 5%. Employees will be more aware of their disability insurance and, if they are paying the premiums, may feel more entitled to benefits.

The chart to the right shows the level of after-tax income replacement for a single person earning $3,500 a month under three Long Term Disability (LTD) plans: 60% noncontributory, 50% gross-up, and 60% contributory (employee pays 100% of premium). Which plan design would you recommend? Send your answer with a brief explanation to .