[Editor's Note: This is a guest post from insurance agent Lawrence B. Keller, CLU, ChFC, CFP®, a long-time contributor and reader who now also sponsors both the blog and The WCI Scholarship (have you contributed yet?) This particular post discusses a common rider that is usually offered as part of a disability insurance policy. Enjoy!]
What Is the Cost of Living Adjustment Rider?
The Cost Of Living Adjustment Rider (COLA), which is optional, is designed to help your disability insurance benefits keep pace with inflation. COLAs generally adjust your policy's monthly benefit annually, based on a fixed percent or tied to the Consumer Price Index, after you have been disabled for 12 months. These adjustments apply to both 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, but is it worth purchasing?
COLA Rider vs Buying Additional Coverage
My general rule is that the younger you are and the less assets you have [and thus the longer until you become financially independent and can drop the policy-ed], the more important the COLA Rider is for you to include as 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 the premiums for the COLA Rider, you may not realize as much of an economic benefit from the rider.
Let’s assume that you are a 35 year old male General Surgeon in the State of New York earning $400,000. You were going to purchase $12,000 month (although you qualified for $16,000 but wanted to reduce your premium outlay), payable after 90 days, to age 65 from MetLife with an Enhanced Residual Disability Rider and a 3% Compound COLA Rider, the monthly premium would be $443.84, including a 10% discount through the American Medical Association. If you removed the COLA Rider, the monthly premium would be reduced to $336.56, a savings of $107.28 or approximately 24% of the cost of the policy.
If you took that premium savings, how much additional coverage would that allow you to purchase? A policy for $16,000 month, payable after 90 days, to age 65 would have a monthly premium of $447.19, including a 10% discount through the American Medical Association – almost identical to the premium for the $12,000 monthly benefit with the COLA Rider included!
So, does it make sense to forego the COLA Rider? What’s the break even period? That is easy to calculate. If you took $12,000 month and invested it at a 3% compound rate of return, it would take 10 years for the $12,000 to grow to $16,127. Remember, the COLA does not begin until your disability has lasted for 12 months.
[Editor's Note: Thus, for any disability lasting less than 10 years, or more depending on what time value of money you assign for getting the money up front, you're better off buying additional coverage rather than a COLA. The average claim is less than 3 years and 62% are less than 5 years long. And, of course, if your policy only pays out to age 65, and you're 55 or 60, you'll definitely want the additional coverage rather than the COLA.]
By the same token, if you purchased a policy at 35 with a $12,000 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) would be $6,852,000. While, if you purchased a policy with a $16,000 monthly benefit and no COLA Rider, the maximum potential benefit for the same disability would be $5,712,000. [Note there is no time value of money calculation included in these numbers-the No Cola guy received more money early on, which is more valuable than receiving it later like the COLA guy did.-ed]
Who Should Consider Buying a COLA Rider?
I think this rider is mandatory in the first half of your career. However, since most policies only pay until age 65 or 67, I do not see much reason for someone in their 50s or 60s to be paying for it.
COLA Riders From The Big Six Disability Insurance Companies
While the COLA Rider will most likely not impact which company’s policy you ultimately purchase, let’s review the COLA Riders that the “Big Six” currently offer [your older policy may be different, so read it-ed]:
Berkshire (Guardian) – 3 options – 3% Compound, 3% Compound payable after 4 years (this is known as the 4-Year Delayed COLA which is unique to Berkshire and typically provides a savings of approximately 25% compared to the normal 3% Fixed COLA after disability has lasted for 12 months) and a CPI-Tied Compound COLA Rider with a floor of 3% and a maximum of 6%. Additionally, should you recover, you would automatically retain increases, free of charge, until age 65 or 67 (this feature is unique to Berkshire’s policy).
Principal – 2 options – Up to 3% or up to 6% CPI-tied Compound. Within 90 days after your disability ends, you may adjust the policy to increase the maximum monthly benefit if your monthly benefit was increased by this rider.
Standard – 2 options – Up to 3% or up to 6% CPI-tied Compound. Within 90 days after disability benefits and recovery ends, and while the policy is in-force, you may apply to purchase an increase in the policy’s basic monthly benefit.
Ameritas – Up to 6% Compound CPI-tied or 3% Simple. The adjustment factor is based upon the CPI-U with a maximum of 6% per year, compounded annually. This has the effect of creating a “catch-up” provision for years when the CPI-U Index is less than 6%, and greater than 6% in other years. This COLA Rider includes a provision to purchase the increase in the monthly benefit upon recovery.
MetLife – 3 options – 3% Fixed Compound, 3% Simple or 0-10% CPI Tied Compound. Under the 0-10% CPI-Tied option, MetLife may increase the monthly benefit based on the year-to-year change in the Consumer Price Index for All Urban Consumers (CPI-U). Increases would not exceed 10% of the previous year’s disability benefit amount. Upon recovery, if you are less than age 60, you may be able to increase your coverage up to the amount of the last adjusted monthly benefit for total disability. You must pay a premium for the increased coverage but there are no financial or medical underwriting requirements.
MassMutual – 1 option – 3% Fixed Compound. Upon recovery you will have the opportunity to purchase additional monthly benefit under the policy. The maximum additional monthly benefit available will be computed from the accrued percentage increase on which the last increase and monthly benefit was based.
Ideally, should you decide to purchase the COLA Rider, I would suggest one that is compounded [as opposed to simple interest-ed] and the higher the maximum, the better, taking overall policy premium into consideration. While my edo Ixample above used MetLife’s 3% Compound COLA Rider, a similar analysis can easily be done for other companies.
What do you think? Did you get a COLA rider on your disability policy? Why or why not? Did the terms of the COLA affect which policy you bought? Comment below!