As more retirement benefits are provided throughdefined contribution (DC) plans, attention isneeded to focus on risk protection, specifically with long-termdisability.

However, many employers do not focus on how disability canthreaten retirement security for their employees – which isalarming because a period of disability usually means no newretirement savings, and may mean accumulated savings arewithdrawn and spent on immediate expenses.

Prior to the transition to DC plans, it was common fordisability to be addressed through a combination of disability benefits, disability provisionsembedded in defined benefit (DB) pension plans, waiver of premiumprovisions in life insurance plans, and at times, continuation ofmedical benefits to disabled employees.

With the shift to DC plans, the DB plan disability provisionsthat protected retirement security have often been lost, so thereis significantly increased risk that mid-or late-career disabilitywill derail retirement security.

This article offers insight into the relationship betweendisability and early retirement, reviews sources of longer-termdisability coverage, and provides ideas about how employee benefitscan enhance financial security during retirement.

Disability is not well understood: Faces and keystatistics

Disability can have a devastating effect onworkers and their families.

Depending on the structure of benefits, long-term disability(LTD) may mean loss of earnings, no further retirement savings,high health costs, and the need for family to care for the disabledindividuals.

Consider a few facts:

One in eight workers will be disabled for five years or morebefore they retire. One in four of today’s 20-year-olds will bedisabled before they retire, according to the Council for Disability Awareness, 2013.

Sixty-nine percent of workers in the private sector have noprivate LTD insurance, also according to the Council for Disability Awareness, 2013.

90 percent of Americans underestimate their chances ofdisability, and 85 percent express little concern that they willsuffer a disability lasting three months or more.

Disability and emerging patterns of retirement

DC plans are unlike DB plans since they do not have built-inincentives for people to retire at a particular time. With morepeople retiring later, there is a need to examine how disabilitybenefits link to emerging retirement patterns.

Current employer-sponsored disability programs are designedprimarily for people who retire all at once and do not specificallyrecognize people who retire from one occupation and later work inanother.

Fitting disability security with emerging work and retirementpatterns is an issue for public policy-makers, insurers, employers,and advisors.

A commonly proposed solution for people who have inadequateretirement savings is to work longer.

A number of actuaries and other pension professionals talk aboutthe need to increase retirement ages as people live longer, butdisability benefits need to be adjusted in order for this to workwell overall.

Longer periods of work make the topic of disability andretirement benefits more important.

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Disability and retirement security: DC disability benefitdesign questions

In DC plans, the employer and/or the participant makecontributions to an individual account on behalf of theparticipant, who bears the investment and longevity risk.Contributions are typically based on compensation.

The total benefit available to the participant at retirement (orsome other permitted distribution event) is based on their accountbalance, which consists of employer and participant contributionsand any investment gains.

Logically, it makes sense to offer the equivalent of a waiver ofpremium provision and include continued savings in the DC plan, butthis is not usual practice.

Such a provision parallels the use of continued benefit accrualin a DB plan, but does not parallel other methods historically usedfor treating disability within DB plans. This issue is much moreimportant when the DC plan is the primary retirement vehicle.

Any period of time when a participant cannot continuecontributions to their account balance has an impact on theirsavings at retirement. An employee who is disabled from ages 50 to55 will lose five years of retirement savings (and the investmentearnings thereon) that they will usually not be able to recoverover the remaining working career.

There are a number of questions to be asked if a DC plan is toadd a disability benefit, such as these:

• Will we cover both employer and employee contributions?

• Who will pay for the benefit?

• If the cost is shared, what approach will achieve the bestoverall outcomes?

• If contributory, how often are contributions adjusted?

• If the benefit is voluntary, how do we deal withanti-selection?

• How best can we manage the risk and/or insure the benefit?

There are also questions to be resolved to administer thebenefit:

• Will elections be handled as part of the annual enrollment? Ifnot, how?

• How do we collect contributions if contributory?

• Are claim determinations made together with LTD claimdeterminations?

• Will all covered people also have LTD? If not, what do we needto do to manage this program?

• How do we transfer claim funds to the 401(k) record-keeper sothey are correctly allocated to participants’ accounts?

Legal and tax issues also need to be resolved. Here are someexamples of conceptual approaches that can be used to make up lostsavings:

Continue employer contributions during disabilityperiod. This seems analogous to a waiver of premiumprovision in life insurance.

Implement alternative savings option outside of DCplan. The employer purchases additional LTD insurance(i.e., current income replacement insurance) on behalf of itsemployees. Upon the occurrence of a disability and the subsequenttriggering of payments under the LTD policy, the proceeds from thisadditional coverage are invested on behalf of the participant in anannuity or IRA. The proceeds of the investment supplement theretirement benefit otherwise accumulated under the DC plan.

Purchase “LTD 401(k) Insurance” as an investment in theDC plan. The participant elects to have a portion of theirown (and possibly employer’s) contributions to purchase LTDcoverage offered as an investment option under the plan. Insuranceis funded either through a LTD policy or a voluntary employeebenefits association (VEBA) established on behalf of one or moreemployers. In the event of disability, the insurance carrier payscash to the participant’s account in the amount of thecontributions they (and possibly their employer) were making priorto disability.

From an actuarial and risk management perspective, each of theseapproaches can work to support continued accumulation of funds forretirement, but none was trouble free in the regulatory environmentin 2012. [ERISA Advisory Council, 2013]

Further research is needed in the evolving legal environment.Individuals can also solve the problem through the purchase ofindividual insurance to replace retirement contributions. In anycase, care is still needed to see that funds are not withdrawnearly.

What employers can do today to enhance security in a DCworld

It is important to find ways to increase employee participationrates in LTD benefits and capitalize on the advantages ofauto-enrollment in the LTD plan.

Employees without LTD coverage will likely tap into theirretirement savings if they are disabled. This is an issue foremployers, insurers, and public policymakers.

Employers and employees need a greater awareness of the issuessurrounding disability and the catastrophic nature of LTD,including the impact on retirement income.

There is also a need to help people who are disabled continue tosave for retirement for themselves, since using retirement funds attime of disability risks leaving no assets for future retirement.This is a potential problem with plans that pay a lump sum at timeof disability.

It is important for employers providing retirement securitythrough DC plans to focus on these issues and think beyond the DCplan for risk protection. Ideally, plan sponsors will provide moreemployee-friendly direct disability benefits integrated within DCplans, such as these:

• Disability insurance as an investment option in the 401(k) oroutside of the plan.

• A generous after-tax group LTD program, and encourage employeesto make contributions to a tax qualified plan and an IRA up to theapplicable limits. Use auto-enrollment to increaseparticipation.

• A voluntary disability program to purchase added coverage on anindividual basis to make up retirement savings.

• Communicating the importance of not dipping into retirementsavings during disability. Help employees understand the need toplan for disability.

• Exploring creative ways to share costs with employees that mightdrive good participation and enhance retirement readiness if theprogram is partly employee paid.

• Helping disabled employees get rehabilitated and return to theworkforce. Offer good job options to such employees.

At the same time, financial planners can do the following:

• Educate clients about disability risk including retirementsavings not continuing during disability.

• Help clients secure adequate disability coverage. Reviewemployer-sponsored coverage and generally encourage enrollment insuch coverage. Help them capitalize on one-time opportunitiesduring job or benefits change, and alert them to the importance offocusing on benefits offered without evidence of insurability onlyat initial enrollment.

• Supplement employer-sponsored coverage with individual coverage.Select reliable insurance carriers.

• Evaluate whether riders to protect retirement savings and thosethat offer inflation protection are needed.