Cost of Living Rider

Inflation has a devastating effect on buying power.  The problem of inflation -- caused erosion of buying power is even greater for your disabled client, however, since the client cannot increase income to compensate for it.  The solution to the problem of inflation for disabled individuals lies in the Cost of Living Adjustment riders, also called COLAs.

A COLA rider adjusts the amount of monthly disability benefit received by the insured each year during his or her disability.  The first adjustment is on the 13th month of disability.  The adjustment that is made in the monthly benefit depends upon the way the rider is designed.  There are three approaches taken by COLA designers.

Under the most common COLA approach the amount of the adjustment made each year is based on the CPI-U, the Consumer Price Index for urban consumers.  Although we are generally accustomed to thinking of COLAs as increases, a COLA adjustment may be up or down.  The monthly disability benefit paid, however, may not be less than the benefit amount shown in the policy.  

To see how this COLA design might work for any client, let's consider an example.  Suppose that our client purchased a disability income insurance policy with a $1,000 per month total disability benefit and a COLA rider providing an annual adjustment based on the CPI-U up to a maximum of 7% yearly.

Let's further suppose that during the first year of disability, the CPI indicated that inflation grew by 5%.  As a result of that inflation growth, our client's monthly benefit will grow by 5%.  Therefore, in the second year of disability, the client's monthly benefit is 105% of the amount at which it began, or $1,050.  ($1,000 x 1.05 = $1,050)

But, what if, in the next year, the CPI-U is a minus 1% as the economy experienced deflation?  The benefit payable in the third year of disability would then reduce under most COLA riders that are based solely on the CPI. The total change in the CPI after the onset of disability is 104% since the change in the CPI was plus 5% in the first year and minus 1% in the second year.  As a result, the benefit payable in year 3 is 104% of the initial $1,000 or $1,040.

There have not been many periods in U.S. history when the country experienced deflation.  However, the client with a COLA rider should realize that his or her benefit can reduce if the CPI is negative.  As we noted earlier, however, the benefit can never fall below the monthly amount that was purchased.

We just looked at the operation of a COLA rider tied solely to the CPI.  When we began this discussion of COLAs, we noted that there are three approaches to COLA design.  A second approach to COLA design increases benefits each year of disability by a certain percentage -- regardless of the direction of the CPI.  The typical percentage increases in the COLA riders are 3% and 5%.  

The final COLA design employs a combination of the methods used in the other two.  It combines a benefit increase based on the CPI coupled with a minimum guaranteed increase.  The minimum guarantee is usually 3%.  

When the CPI is greater than the guaranteed minimum, the increase is equal to the CPI; in years in which the CPI is lower than the guaranteed minimum, the guarantee comes into play.  

In order to impose an upper limit on claims, the maximum increase is almost always limited to some maximum amount.  The total increase in the monthly benefit under any of these approaches is usually limited to 2 or 3 times the initial monthly benefit.  Furthermore, in those COLA riders whose adjustments are based on the CPI rather than a guarantee, the maximum increase in any year is usually limited to 7% or 10%, depending on the rider.  

Even in successive years of inflation, it's unusual for the inflation rate to remain constant; in some years it may be 3% and 10% in others.  Those COLA riders with an annual limit on the COLA increase will often contain a "catch-up" provision.  A catch-up provision in a COLA rider allows a monthly disability benefit to increase based on previous CPI increases that were in excess of the permitted annual COLA increase.  

Let's consider another example.  Suppose that our client's COLA rider was CPI-indexed and contained an annual increase limit of 7%.  Our client became disabled, and the CPI increased 10% in the first year of disability, 3% in the second, 8% in the third and 5% in the fourth.  What would happen to his benefit?

At the end of the first year of disability, our client's monthly disability benefit would increase by 7%, the maximum that it can increase in any given year.  In the second year of disability, the CPI increased by only 3%.  However, rather than the benefit increasing by only 3%, it is increased by that year's CPI change plus previous CPI increases since the onset of disability that are not yet reflected in the benefit.  As a result, the benefit increases by 6% -- a combination of the current 3% change in the CPI and the previous year's 3% change that was in excess of the COLA maximum.

The actual increases in our client's monthly disability benefit will tend to catch-up to the changes in the CPI as shown in the following table:

 Year
Annual  
CPI
Increase
Aggregate
 CPI
Increase
Annual  
Benefit
Increase
Aggregate
Benefit
Increase
 1
 10%
 10%
 7%
 7%
2
3%
13%
6%
13%
3
8%
21%
7%
20%
4
5%
26%
6%
26%



 We have been looking at the effect of the COLA rider on the total disability benefit payable.  However, the COLA rider may affect the residual disability benefit payable as well.  The COLA's effect on the residual disability benefit results from the action of the COLA on pre-disability earnings.

When we examined the residual disability benefit, we noted that the amount payable was the percentage of income lost multiplied by the monthly benefit for total disability.  So, for example, if the insured had pre-disability earnings of $10,000 per month that were reduced to $4,000 because of sickness or injury, he or she would have suffered a 60% loss of income.  If the insured's disability policy provided a $6,000 total disability benefit, the residual disability benefit would be $3,600 -- 60% of that amount.

But, what if the policy contained a COLA rider and the CPI increase by 7%.  Let's look at its effect on the residual disability benefit.

Since the change in the CPI affects the pre-disability earnings, the $10,000 of pre-disability earnings are increased to $10,700.  ($10,000 x 1.07 = $10,700)  To make the illustration clearer, let's assume that the insured's residual earnings remain at $4,000 monthly throughout the period of disability.  In the second year of residual disability, the residual disability benefit would increase to $4,020.  ($6,700 ÷ $10,000 = .67; .67 X $6,000 = $4,020)