As the cost of goods and services rise each year, the purchasing power of a set amount of money decreases. For example, the average cost of a new home in the U.S. in 1997 was $179,500; today it’s more than double at $368,000.
That’s why it’s important for workers to receive an increase in income each year.
But what if you’re receiving disability benefits because of an injury or illness that prevents you from working in the medical field? If those benefits don’t increase, their purchasing power will slowly erode the longer you’re unable to work. That’s where a cost of living adjustment rider can help.
To help offset the risk of inflation, most disability insurance companies offer cost-of-living adjustment (COLA) riders which can be added to your disability insurance policy.
A COLA rider is an optional add-on to a long term disability insurance policy that will help any benefits that you are paid keep pace with inflation in the event that you become disabled. If your policy has this rider, your benefits will increase annually, typically starting after you’ve been disabled for 12 months. This rider will increase the premiums you pay for your disability insurance policy.
It’s important to note that a cost-of-living adjustment rider kicks in when you become disabled, and won’t make up for the period between when you first purchased your policy and when you filed your disability insurance claim.
There are typically two ways that insurers factor benefits increases.
The first is a fixed percentage increase, such as 3 percent annually, that will remain unchanged for as long as you collect benefits. The other is using a third-party index, such as the Consumer Price Index. If the index increased 2.5 percent during the year, your benefits will increase 2.5 percent.
Riders that pay a fixed rate for COLAs typically increase benefits by 3 percent. Those that are based on a third-party index will set a minimum of 1 percent or 2 percent, and a maximum cap, usually 6 percent.
Some disability insurance carriers, such as Ameritas and Ohio National, offer clients a choice between a 3-percent fixed rider and one based on the Consumer Price Index with a minimum and cap.
If your policy’s rider pays a fixed percentage, you should verify whether the increase uses simple interest or compound interest.
Simple interest increases the amount based on the original benefit amount. For example, if you receive $10,000 in monthly benefits with a COLA rider that pays 3 percent simple interest, your monthly benefits will increase $300 every year. So in the first year, your benefits will be $10,000 a month. In the second year, your monthly benefits will total $10,300. In the third year, your benefits will equal $10,600.
Compound interest is calculated on the principal and also any accumulated interest. So using the above example, benefits for the first and second year will be $10,000 and $10,300, respectively.
But in the third, instead of adding just $300 like with the simple interest calculation, the 3 percent adjustment is based on the previous year’s benefits of $10,300. So the increase will be $309 (10,300 x 3%) so your monthly benefit in the third year is $10,609. You would then add 3 percent to that total to get your fourth-year benefit of $10,927.27 (10,609 x 3%).
Each company’s cost of living adjustment rider can vary based on what happens to the benefit amount once you return to work. Some riders reset the rider back to the original benefit amount that your policy started with. For example, say your original benefit was $10,000 a month. After three years with a 3 percent fixed annual increase, you were receiving $10,600. Then you returned to work, at which point benefits stopped. If you became disabled again, your benefits would reset to $10,000.
Some insurers enable you to purchase the additional increase from the COLA rider, which will increase your premium. Others will allow you to continue your policy benefit at the increased amount without increasing your premium.
In addition to comparing COLA riders, it’s important for doctors to consider whether the rider benefit is worth the increase in premium.
The younger you are, the more you should consider a COLA rider. Without the rider, your benefit amount will remain the same for the length of your benefit period. If inflation averages 3 percent a year, your level benefit amount will have a third less purchasing power in 15 years. A COLA rider, on the other hand, will help your benefit amount keep pace with inflation for as long as your receive payments. It’s also important to note that a COLA rider can make other riders on your policy more expensive. For example, a COLA rider can make it more expensive to have an own occupation rider on your policy.
According to the 2018 Report on Long Term Disability Insurance for Doctors, approximately 72 percent of doctors have a cost of living adjustment rider in their policy. Of those that have a COLA rider, an estimated 94.8 percent have a 3% increase while only 5.2% have a 6 percent increase cost of living adjustment rider.
Jack is a Creighton University graduate and former advertising creative who has written extensively about topics in personal finance, employee benefits, and technology. You can find Jack's writing on Calendar.com, StartupNation, and Muck Rack.