In the past, the general approach to compensation design focused on a combination of current and deferred earnings while de-emphasizing the benefit package. Smaller salary increases have resulted in some executives looking for better benefit packages. One such area is long term disability (LTD) benefits.

LTD, often a component of an executive’s employee benefits package, is often misunderstood. A comprehensive financial plan should include evaluation of whether such benefit is adequate or not. The first source of information is the Benefit Booklet or Certificate of Coverage which will show the conditions that must be satisfied as well as the formula for calculating how much the executive will receive during a disability.

This formula will consist of a percentage amount as well as stipulated maximum benefit (“ceiling”). An example of such a formula is “66-2/3% of earnings to a maximum of $6,000”. In addition, the plan will outline a maximum the employee can collect from all sources (known as the “all-source maximum”). How ‘earnings’ is defined also impacts the benefit calculation.

In summary then, the actual amount that the employee will receive is not necessarily 66-2/3% of their full earnings, or $6,000, but rather the lesser of the following:

a) The stated percentage (eg. 66-2/3%) b) The stated maximum (eg. $6,000) less direct offsets (more to be said about this later in this article)
c) The all-source maximum

Stated Percentage

Standard formulas are used by insurers such as 60%, 66-2/3%, 70% or 75%. This percentage is applied to the pre-tax earnings. Higher percentage amounts are used when the employer is paying the premium and therefore, the benefit during a claim is taxable as income. The advantage to the employee is that contributions can continue to be made to RRSP during periods of disability because the executive is still receiving ‘earned income’. Lower percentages are used when the employee is paying the premium and therefore, the benefit during a claim is nontaxable. This may result in a higher replacement during disability when compared to the net benefit under a taxable formula.

Many plans are based on graded benefit formulas such as 66-2/3% of the first $4,000 and 60% of the balance. The purpose of this is to avoid paying premiums on benefit levels that would only be cut back during a disability based on the plan’s all-source maximum. Known as ‘double-splits’ or ‘triple-splits’, the formula is selected with consideration to the earnings levels of the company’s executives to determine where the all-source cut back begins indicating payment of unnecessary premiums.

Earnings Definition

Many executives receive a substantial portion of their income through bonuses and other profit-sharing incentive plans. Therefore, it is critical to check how the LTD plan defines ‘earnings’ since that affects the calculation of benefits. Many plans define earnings as ‘base salary excluding bonuses, commissions, and overtime pay’. An executive who receives a $60,000 annual bonus each year will be grossly underinsured through such a formula.

The Stated Maximum Benefit

Smaller companies generally have lower maximum limits such as $2500 or $3500. Large corporations may have a maximum set as high as $15,000. Some employers design their LTD plan with a lower maximum as a cost containment measure . Higher maximums generally result in a load or extra charge to the premium rate.

The All-Source Maximum

The benefit booklet will state a maximum that the employee can receive from all sources during a disability. An example is 85%. The sources of income that must be considered will also be defined the booklet. Two primary categories of sources are direct offsets and indirect offsets. The Direct Offsets method is the less restrictive version, and requires deducting amounts for primary disability benefits under the Canada Pension Plan that the employee is entitled to receive (i.e. without regard for whether they are in receipt of it). Other sources may include WSIB.

Individual disability policies covering the executive are usually not included in this calculation, unless the individual policies are corporate-owned and corporate-paid, and the LTD definition specifically states income received from other ‘wage-loss replacement plans’.

Indirect Offsets include a broader range of deductions such as entitlement to CPP to the disabled contributor for their spouse and/or dependent children.

The end result, is that the actual benefit payable during a disability to a disabled executive may be significantly less than first assumed. The fact that a company’s higher paid executives are impacted while lower paid staff are not is a phenomenon referred to as the paradox of reverse discrimination.

The solution for executive compensation planning is for the corporation to create a combination program utilizing a blend of Group LTD and Corporate-owned Individual Disability insurance. This method delivers the ‘best of both worlds’ by combining the cost-effective elements of Group LTD with the flexibility and customization elements of individual plans.

More information is available on this topic through Figas & Associates Individual and Group Benefits Planning at www.figasinsurance.com.