Disability Insurance: Cost of Living Adjustment Rider

The cost of living adjustment (COLA) rider is an optional benefit rider that increases a policyholder’s monthly benefit on an annual basis, based on a fixed percentage or a corresponding increase in the consumer price index, after you have been disabled for more than 12 months.

Since the monthly benefit is adjusted upwards and typically tied to the rate of inflation, it can help offset the impact of inflation on the benefit amount you’d receive in connection with a total disability or residual disability. If your monthly benefit isn’t being adjusted upwardly, technically, you are losing purchasing power each year as your ability to buy goods and services with your monthly benefit decreases as the cost of those goods and services increases due to inflation.

Since this disability insurance rider is an add-on to your existing disability insurance policy, it can be expensive and you may be better off using the funds to purchase a bigger disability insurance policy (since you can reallocate the money you would have spent on the rider to purchase a larger policy with a bigger premium).

COLA rider vs. buying a larger disability insurance policy

When deciding between purchasing a COLA rider or buying a larger disability insurance policy, the first question is whether you’re purchasing the maximum coverage available to you based on your annual income.

If you’re not purchasing the maximum amount of coverage available to you, it often makes sense to skip purchasing the cost of living adjustment rider and instead reallocate those dollars towards purchasing a larger policy with additional coverage.

For example, you may be able to purchase up to 25% of additional monthly benefit by reallocating dollars from the COLA rider to a premium for a bigger policy. This likely means that it would take about ten years for the monthly benefit from the COLA rider to catch up to the monthly benefit you’d get from the bigger policy.

These calculations are easy for your insurance agent to make on your behalf and underscore the importance of working with an expert in disability insurance (not to mention navigating things like own occupation, exclusions, life insurance, etc.)

If you’re purchasing the maximum amount of coverage an insurance company will sell you, the COLA rider becomes a more important consideration because you can’t reallocate the COLA rider money to purchase a bigger policy.

Should I purchase a cost of living rider?

In situations where you’ve maxed out the coverage available to you on the disability insurance policy, the COLA rider generally becomes more important the younger you are. If you’re young, the COLA rider will have more time to provide you benefit increases on a compound basis because you possibly have a longer benefit period in which to collect monthly benefit payments.

On the other hand, if you’re young and farther away from financial independence (when you can cancel a disability insurance policy), the COLA rider comes with an increased cost because you’ll be paying the additional premium for the life of the policy.

Most high-income professionals will want to purchase a cost of living adjustment rider during the first half of their career. The risk of becoming totally disabled in your 30s or 40s without a cost of living adjustment is too great.

This is particularly true given that most disability insurance policies stop paying benefits when you reach 65 or 67, meaning that you’ll also need to consider retirement planning when allocating your disability insurance policy’s monthly benefit.

If you’re purchasing a policy in your late 40s or 50s, the COLA insurance rider may be less important to you because the purchasing power of your disability income will not have as much time to be eroded by inflation.

Can I cancel the COLA rider after I purchase the disability insurance policy?

Since financial planning involves predicting future events and it’s hard to predict what disability benefits you’d need if you suffered a partial or catastrophic disability, it’s often difficult to decide if paying extra for a COLA rider makes sense today. 

If you factor in the unpredictability of the CPI inflation index–like most insurance benefits–the COLA rider may not be something you need, unless you need it (how’s that for clarity!).

The good news is that if you add a COLA rider to your base policy, most insurance companies will allow you to cancel this policy benefit if you later decide that you don’t want it. I think this makes it easier to decide to purchase the COLA rider today–particularly if you’re young–since you know that you can drop it later. You should consult with your insurance agent to confirm that this is the case before you purchase your individual disability insurance policy.

The most important part of a disability insurance policy is that you have one in the first place. If you’re relying on social security, or that you’ll be healthy enough at some point in the future to get through an insurance company’s underwriting process, you’re taking a risk that can easily be taken off the table by a high-income professional who is thoughtful about personal finance and planning.

Joshua Holt is a licensed insurance agent (License #2785989) and founder of Biglaw Investor and Sidebar Insurance LLC, an insurance agency created by lawyers, for lawyers. His insurance expertise lies in the areas of life and disability insurance, particularly covering lawyers, doctors and other high-income professionals. Prior to Biglaw Investor, Josh practiced private equity mergers & acquisition law for one of the largest law firms in the country.