When the topic is group disability insurance, master swordsman Inigo Montoya from the 1987 movie Princess Bride might reply: “You keep using that word ‘covered.’ I do not think it means what you think it means.”

Montoya’s skepticism is justified. What is considered “covered” by an employer’s group disability plan may leave some employees far more exposed to financial hardship than they assume, when they are told the policy will replace 60 percent of income. It’s not until you get answers to the question “60 percent of what?” that you can be sure your income is protected.

A quick overview of disability insurance metrics:

• If disability insurance benefits fully replace one’s income, there is a potential moral hazard: It may be more desirable to collect disability than work. Consequently, insurance to replace 60 percent of one’s income is an industry benchmark for most group disability plans.

• Insurance companies assess premiums in keeping with the benefits they anticipate having to pay. To control costs, a group plan usually places limits on benefits, either by imposing a cap on monthly payments, or by limiting the definition of income to base salaries while excluding variable compensation like bonuses.

• If the premiums are paid by the employer, any benefits received by an employee are considered taxable. Conversely, when the employee pays the premiums (typically through payroll deduction), benefits are non-taxable.

From just these three factors, it’s easy to see how critical it is to understand “60 percent of what?” Is it 60 percent of base salary? What items are included in the base? Is there a monthly benefit cap? Are benefits taxable or nontaxable?

Calculating benefits can be complex and confusing. Some employees with incomes on the lower end of the payroll might receive 60 percent of compensation in the event of disability, while others—in the same plan—could be covered for as little as 20–30 percent of their net take-home pay after taxes. Consider this example, provided by Gary Terry in an April 2013 trade publication article:

The vice president of sales for a consumer products company makes $400,000 per year, which includes a base salary of $250,000 and a bonus of $150,000. He is suddenly hospitalized for complications from diabetes and he goes out on long-term disability. It’s his belief that his monthly disability income will be $20,000 per month ($400,000 x 60 percent divided by 12 months). Think of his surprise when a monthly check shows up in the amount of $12,500 ($250,000 x 60 percent divided by 12).

For this vice president, his 60-percent-of-income benefit is actually 37.5 percent—and it might be lower. If the group plan has a monthly benefit cap of $10,000, or these benefits are taxable because the employer paid the premium, the net benefit drops to around 25 percent. To repeat: “Covered” may not mean what you think it means.

Completing Your Coverage With Individual Disability Insurance

Employees, especially those with high and fluctuating incomes, should consider addressing potential group-plan shortfalls by securing additional coverage through an individual disability income replacement policy. This can not only fill the gaps in a group plan, but may allow the total disability benefit to exceed the 60 percent group threshold. Better still, in many cases, a single individual policy can provide a lifetime of valuable income protection.

• Most individual disability policies are non-cancelable and guaranteed renewable; as long as you pay the premiums, the benefits can’t be changed or eliminated.

• Individual disability insurance is portable; if you change employers, you can take the policy with you.

• Benefits from an individual policy usually are not diminished or coordinated with benefits that may be paid by worker’s compensation or Social Security.

Adding individual disability protection is a personal project, not an employer-sponsored benefit. Most individual policies involve underwriting; an application will be submitted, a medical exam and income documentation may be required. And premiums will typically be paid by the insured, not the employer.

By Elozor M. Preil