The Disability Diagnostic Series: COLA Rider
By D.K. Unger
The Cost of Living Adjustment (COLA) rider is an optional rider that is commonly added to individual disability insurance policies. The purpose of the rider is to keep disability benefits in pace with inflation. I will examine what the rider actually does and whether it is cost-effective.
The COLA rider generally works as follows. After one year of a disability for which benefits were payable, and each disability anniversary thereafter, the monthly benefit amount of the policy can be adjusted upwards depending on the percentage change in the Consumer Price Index (CPI). Increases are subjected to a cap of either 3% or 6%. The benefit will not decrease if the CPI decreases.
Now let’s examine the cost of the rider to determine if it is a good option. For a non-invasive male physician in California with an $8,000/month benefit, adding the 3% COLA rider to the policy would cost nearly $800 additional per year. That is close to 25% of the cost of the base policy benefit ($8,000/month) and base features. If this physician instead chose to use the COLA rider premium to pay for additional monthly benefit, he would be able to establish close to an additional $2,000/month in base benefit.
Remember that the COLA rider only kicks in after one year of disability. After that, it can increase depending on the percentage change in the CPI. For our physician with the $8,000/month benefit and COLA capped at 3%, he would have to be continuously disabled for 8 years and the CPI would have to be at 3% for each and every one of those years before his monthly benefit would reach $9,900/month.
For his twin brother, who opts to buy the $9,900/month benefit instead of $8,000/month with COLA, he would receive the $9,900/month in the first year and any year thereafter. In the long run, this could pose a problem if the disability is 10 years or longer and inflation runs high for the duration of the disability.
With the average length of a disability between 5 and 7 years, the COLA rider does not appear to be cost-effective. It would be advantageous to instead purchase additional base benefit. This is a general recommendation, and I would be more inclined to add the COLA rider to a policy if the insured is younger than 35. Ultimately, whether the COLA rider is added to a policy is a case-by-case decision.
Contact me today if you have any questions regarding the COLA rider on your current policy or on a policy you are considering establishing.