Disability and Risk Management

RCG

Benefits Group

By: Charles T. Lanigan JD, CLU

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Disability, Risk Management Executive Compensation Plans

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ost executives are familiar with the basic concept of risk management. Risks that may seem to be relatively slight when viewed from the perspective of a single individual over a short time frame become virtual certainties when considered in larger groups over extended time periods. The more significant and unpredictable, the more important it can be to “hedge” against loss and incur a relatively small, budgeted annual expense to protect against the “big hit.” Liability insurance or workers compensation are classic examples of this type of business risk management.

These same principles of risk management should be applied to a company’s executive compensation plan. An executive compensation program is arguably the most important obligation a business has, both in terms of expense and in terms of the successful execution of a company’s business plan. Through the compensation program, the executive and the company have entered into a contract with their key performers. If each party meets their obligation, there will be financial rewards in accordance with the terms of the plan. But what if the executive dies or becomes disabled? What becomes of the contract then? What is the impact on both parties? Outside of business failure, the greatest threat to the successful realization of the goals of the executive compensation program is death or disability.

The Relative Risk of Death vs. Disability

The risk of death is generally well understood. For a white collar executive, there is a 20.4% chance that a 45 year old executive will die before age 65. Most executives would not think of leaving their family’s financial well-being exposed to risk of that magnitude. Some form of life insurance is routinely an element of the executive compensation program.

Unfortunately, the disability risk as it relates to executive compensation planning is not well understood. By way of contrast, the risk of disability, compared to the risk of death for the same person before age 65 is 26.3 percent!

The reality is that while death is inevitable the risk of disability is greater at any point in time. And the disability risk doesn’t stop at 65—after retirement the risk of disability skyrockets. There is a 60 percent chance that a person over 65 will need long-term care in their lifetime. The significance of the disability exposure and the importance of hedging a compensation plan against it are best understood by examining the nature of executive compensation plans.

Relating the Disability Risk to Executive Compensation Plans

Executive compensation plans are designed to attract, retain and motivate key talent. These plans are comprised of a package of compensation elements related to the production of current income and the accumulation of assets. These elements are: ¾¾Salary (current income) ¾¾Short and long-term incentives (both current income and

accumulating assets)

¾¾Retirement programs (accumulating assets) ¾¾Benefits (protecting income and assets) ¾¾Perks (motivation)

The disabilities that are of greatest concern to a compensation plan are those that last longer than a year. The reason for this is simple: most companies will terminate a disabled executive who has been disabled for a year (I suggest that you test that assumption with your own HR department). Statistics indicate that over 54% of executives disabled more than a year are still disabled five years later. Let’s examine the effect of a longer term disability on each of these elements: Salary: Most executives participate in the company group LTD program. These plans have caps and

limitations. The result is that most executive salaries are under-insured.

Short and Long-Term Incentives: Group LTD plans generally do not cover incentive income at all. When incentives are factored into total income, the level of protection afforded by group LTD plans leaves most executive incomes significantly under-insured.

Retirement Plans: Traditional Retirement plans, supplemental retirement plans, deferred compensation plans, and 401(k) plans all play an increasingly important role in executive compensation as the executive enters their prime earning years. Retirement plans usually provide vesting of accrued savings. But that’s it. New contributions stop. Making voluntary contributions to savings once one is disabled becomes difficult if not impossible, especially if income is drastically cut. It is important to realize that expenses go up, not down for the disabled.

Perks: Perks come to an end with the disability. Realistically, the loss of perks is the least of the executives concerns when disabled.

Impact of a Disability on Total Income

The following chart illustrates the potential financial impact of a long-term disability prior to retirement, under three distinct, but not uncommon, income scenarios. Executive one is a senior manager with a relatively high base salary but with a significant portion of income derived from incentives. Executive two’s income is predominately base salary with a 25% bonus. Executive three is a personal producer, with a smaller salary with a high percentage of income derived from sales or investment results.

Current Plan

(60% Income Replaced; $6,000/Monthly Benefit Maximum)

Annual Salary Incentive Income Total Income Monthly LTD Income Replacement Ratio

Executive 1 250,000 100,000 350,000 6,000

Executive 2 150,000 37,500 187,500 6,000

Executive 3 75,000 100,000 175,000 3,750

21%

38%

26%

What these executives have in common is the fact that the company provided group disability program is woefully inadequate to protect their income. The fault does not rest with the group disability plan. These plans are designed to protect the vast majority of employees at an affordable rate for the company. However, while these plans provide a base of protection for the more highly compensated, it is clear that maintaining an executive’s family’s lifestyle would be difficult, if not impossible, with a loss of income of this magnitude.

Loss of Retirement Savings

Loss of income is only part of the picture. The impact of disability before retirement on the executive’s retirement plan can be severe as illustrated in the following example. The example on the following page assumes that the executive is participating in a supplemental retirement program with a target accumulation of $1,000,000 by age 65. The program is based on annual accruals to hit the target. If the executive becomes disabled, the accruals typically stop.

Retirement Disability Example Age

Target Retirement

Annual Accrual Balance

45 50 55 60

1,000,000 1,000,000 1,000,000 1,000,000

27,675 193,857 418,012 720,363

Retirement if disabled (6% earnings)

88,757 464,590 748,600 964,008

Advances in medical science make survival from sickness or accidents ever more likely. However, survival does not necessarily translate into returning to a job from which one was terminated or acquiring another equivalent position. The impact of the disability on retirement assets may be permanent.

Hedging an Executive Compensation Program Against Disability Before Retirement

This exposure can be corrected by “hedging� the executive compensation plan against the threat of pre-retirement disability.

Hedging the Income Risk On the income protection side, the most common approach is to purchase individual disability insurance on top of an existing group LTD plan. The supplemental policy covers both base salary and incentive income. In the example below, the individual supplement combines with the existing group LTD to increase the TOTAL income replacement up to 67%. In the illustration, there is an added catastrophic benefit that is an added feature of many executive supplemental disability policies. This benefit pays an additional sum if an individual is severely disabled. About 10% of disabilities meet this definition. The catastrophic benefit pays added benefits that can bring the total income replacement to 100%.

Annual Salary Incentive Income

Enhanced Plan (Total Income Replacement to 67%) Executive 1 Executive 2 $250,000 $150,000 $100,000 $37,500

Executive 3 $75,000 $100,000

Total Income

$350,000

$187,500

$175,000

Monthly LTD Individual Supplement Monthly Total Benefit Combined Inc. Repl. Ratio Catastrophic Benefit Monthly Total Benefit Catastrophic Disability Replacement Ratio

$6,000 $13,500 $19,500 67% $9,700 $29,200

$6,000 $4,500 $10,500 67% $5,200 $15,700

$3,750 $6,000 $9,750 67% $4,900 $14,650

100%

100%

100%

These kinds of policies can be non-cancellable with guaranteed rates (fully portable), term policies (owned by the individual or the company), or a combination of both, depending on the situation and amount of coverage needed. Depending on the number of lives being insured, guaranteed issue underwriting is available. The cost will vary by age and the type of coverage selected, however, you can estimate that the cost of coverage will be less than 2% of the income being protected. Premiums paid by the company are tax deductible (and not imputed income to the executive) so the net cost is diminished further.

Hedging the Retirement Risk The approach to hedging retirement risk is similar to protecting income in the sense that dollars are needed in the event of a long-term disability. Hedging the retirement risk is based on the concept of providing enough dollars to complete the targeted plan. One approach is to provide a decreasing term policy that is programmed to provide a lump sum benefit if the executive is totally disabled and terminated from employment. Decreasing term coverage is most appropriate for the simple reason that the exposure diminishes as retirement approaches.

Age 45 50 55 60

Retirement Disability Solution Liability “True Up” Annual Accrual Balance

(Insurance Coverage)

27,675 193,857 418,012 720,363

282,049 223,915 145,500 39,730

Target Retirement 1,000,000 1,000,000 1,000,000 1,000,000

In the above example, the insured amount should approximate the amount of currently invested dollars with an appropriate earnings assumption that would produce the targeted benefit at the normal retirement age. Because the coverage is term, the expected cost of hedging this aspect of the compensation program would be expected to be less than 1% of the amount at risk.

Long-Term Care: The Overlooked Component of Executive Retirement Programs

Long-term care is commonly (and mistakenly) thought of by many as a topic for retirees. Nothing could be further from the truth. Long-term care is by far the single largest unfunded liability that an executive will face in retirement. It is not covered by health insurance or regular disability insurance. Government programs are intended for indigents so it is highly unlikely that an executive will ever qualify for government assistance. As a result, the choices are self-insurance or putting a long-term care plan in place.

The high cost of long-term care and the high likelihood of needing it make long-term care a prime candidate for risk management. The best time to put coverage in place is during your working prime, when premiums are affordable and by far the best way to get coverage is through an employer sponsored program.

The Likelihood of Needing Long-Term Care

An individual qualifies for long-term care if they are unable to do certain “activities of daily living” such as bathing, dressing, etc. without stand by assistance. This standard is significant, because it is not necessary to be in a nursing home to qualify. In fact, most long-term care benefits are paid for home care and assisted living. The nursing home is just the end game.

Almost two thirds of individuals over age 65 will need some form of long-term care in their lifetime. There is a 70% chance for married individuals that at least one of them will go to a nursing home. From a risk management perspective, it’s difficult to imagine a greater risk to the financial well-being of a household, including death.

The Cost of Long-Term Care

The national average cost of a private nursing home room is now over $73,000 a year and climbing steadily. Assisted living and home care generally cost about half that amount, still a considerable sum. As mentioned above, the executive (unlike many rank and file employees)

is highly unlikely to qualify for government benefits. It is not difficult therefore to imagine the impact on a family’s resources of one or even two uninsured long-term care events. Because of the high likelihood of occurrence and high cost, protecting retirement assets against the cost of long-term care is an essential part of retirement planning.

Advantages of Hedging the Long-Term Care Risk Through an Executive Compensation Program Employer-paid long-term care programs have numerous features that make them ideally suited for executive compensation programs: ¾¾Programs are non-qualified, which means the company can

choose who participates and can establish different classes

¾¾Premiums are tax deductible to the company ¾¾Premiums are not imputed income to the executive ¾¾Benefits generally are received tax free ¾¾Substantial discounts are available ¾¾Simplified issue underwriting

The net cost to the company of providing the benefit to the executive as opposed to the executive purchasing the coverage on their own (assuming the executive could even medically qualify for coverage on their own) is dramatic: The following is a cost comparison of an employer-paid executive program with a nationally recognized LTC carrier and the same program purchased by an individual. The program is for a $170/day benefit payable for a minimum of five years with unused benefits extending the benefit period. Both programs have a 5% compound inflation protection rider built in.

Year 2010 At Age At Age

Employer-sponsored plan: Age Annual Premium 50 $1,946 65 $1,946 85

Daily Benefit 170 350

$1,946

940

Net after tax cost to employer assuming 35% tax rate: $1,265

Year 2010

Individually purchased plan: Age Annual Premium 50 $2,626

Daily Benefit 170

Year 2025

Individual purchase at retirement: Age Annual Premium 65 $8,557

Daily Benefit 350

Timing is Especially Important for Executive Long-Term Care Programs

The easiest way to illustrate the importance of establishing an employer sponsored executive long-term care program in a timely manner is to compare the above cost at retirement of a company-sponsored program to what it would cost the executive to make his or her own arrangements at retirement.

As already mentioned, employer-sponsored programs provide substantial discounts in addition to enhanced underwriting. Another important aspect of long-term care insurance is the operation of the inflation protection riders. These riders increase the benefit every year without a cap (5% compounding is common), while the premium stays level.

The practical effect of this is that at retirement, when the executive takes over responsibility for premium payments, they have a discounted policy with a substantially increased benefit as compared to what they could purchase on their own.

Relative Cost to the Executive of Long Term Care At Retirement

50 year old OH resident/$170 day benefit/100 day elimination/5% compound inflator/5 yr benefit period/15% employer discount/30% spousal discount/Monthly home care included/Enhanced Home Health Care/Lifetime premium payment 65 year old OH resident/$350 day benefit/100 day elimination/5% compound inflator/5 yr benefit period/No employer Discount/15% spousal discount/Monthly home care included/Enhanced Home Health Care/Lifetime premium payment

In our example, the total cost to the company of providing this type of benefit after tax is $18,975. The benefit the executive receives in our example is worth up to $638,750, an amount that will increase by 5% compounded every year thereafter. By any measure, long-term care is a highly leveraged benefit.

Summary

Risk management is the process of identifying risks that have a high a likelihood of occurrence. It is based on the realization that it’s not whether a loss will occur, but rather when and to whom the loss will occur.

Therefore, in anticipation of the inevitable hit, a company absorbs a regular budgeted expense to hedge against the risk.

This exact logic applies to an executive compensation program. Executives need protection against disability both before and after retirement. The simple fact is that they cannot get the same protection on their own compared to what they can acquire through a company plan. The cost of hedging the compensation plan against these risks is small when compared to the amount at risk. In our view, the case for hedging executive compensation plans against the disability risk becomes compelling.

RCG

Benefits Group

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