If you are unable to work due to a sickness or injury, disability insurance can help you meet your expenses and maintain your standard of living. One of the options available when purchasing an individual disability insurance policy is the cost of living adjustment (COLA) rider.
What Is the COLA Rider?
The COLA rider is designed to help your disability insurance benefit keep pace with inflation. These riders generally adjust your policy’s monthly benefit on an annual basis, based on a fixed percentage or tied to the consumer price index after you have been disabled for 12 months. These adjustments apply to total and residual disabilities and can be based on a simple or compound basis. Although expensive, this rider can provide significant increases to your monthly benefit if you are disabled early in your career.
Is the COLA Rider Worth Purchasing?
My general rule is that the younger you are and the fewer assets you have accumulated, the more important the COLA rider is and the more it should be part of your policy. However, if you are not opting for the maximum amount of coverage that you qualify for based upon your earned income, you should consider removing the COLA rider and using the dollars you would have allocated to the COLA rider to purchase a larger monthly benefit. Remember, the COLA rider will not increase your monthly benefit until you have been disabled for 12 months. Therefore, if you are not disabled for a long-term period, and have been paying premiums for a COLA rider, you may not realize much of an economic benefit from the rider.
Do the Math
Assume that you are a 35-year-old male hematologist-oncologist in New York earning $290,000 per year. You were planning to purchase $10,000 per month of individual coverage from an established insurance company (you qualified for $13,000 per month, but wanted to reduce your premium outlay), payable after 90 days of disability to age 65 years with an enhanced residual disability rider and a 3% compound COLA rider. The monthly premium would be $267, including a 10% association discount. If you removed the COLA rider, the monthly premium would be reduced to $203; this is a savings of $64, or approximately 24% of the cost of the policy.
If you took that premium savings, how much additional monthly benefit would that allow you to purchase? A policy for $13,000 per month, payable after 90 days to age 65 years would have a monthly premium of $262, including a 10% association discount. This is almost identical to the premium for the $10,000 monthly benefit with the COLA rider included.
In this scenario, does it make sense to forgo the COLA rider? What is the break-even period? That is easy to calculate. If you took $10,000 monthly and invested it at a 3% compound rate of return, in 10 years (1 year of disability plus 9 years of investing at 3%), the $10,000 would grow to $13,048.
By the same token, if you purchased a policy with a $10,000 monthly benefit and a 3% compound COLA rider, the maximum potential benefit for total disability (assuming a total disability began on the effective date of the policy and continued until the age of 65 years) would be $5.70 million. If you purchased a policy with a $13,000 monthly benefit and no COLA rider, the maximum potential benefit for the same disability would be $4.64 million.
Ideally, should you decide to purchase the COLA rider, I would suggest one that is compounded, and the higher the maximum is the better, taking overall policy premiums into consideration. While the example above utilized the sample company’s 3% compound COLA rider, a similar analysis can easily be done for most insurance companies.
The COLA rider is designed to help your disability insurance benefits keep pace with inflation. Generally, the younger you are and the fewer assets you have accumulated, the more important the COLA rider is and the more it should be part of your policy. However, if you are not opting for the maximum amount of coverage that you qualify for based upon your earned income, you should consider removing the COLA rider and using the dollars you would have allocated to the COLA rider to purchase a larger monthly benefit.
Lawrence B. Keller, CFP®, CLU®, ChFC®, RHU®, LUTCF, is the founder of Physician Financial Services, a New York–based firm specializing in income protection and wealth accumulation strategies for physicians. He can be reached at 800-481-6447 or by email to Lkeller@physicianfinancialservices.com.