How Social Security Disability Insurance Works

Most people think of Social Security as a retirement benefit, and that's understandable. Among the 61 million Americans receiving Social Security at the end of 2016, 68%--44.3 million people--were retired.

But Social Security's broad aim is to protect against the risk of lost income from work. The income loss might be due to retirement, disability, or to a survivor after the death of a family breadwinner. Last year, 14% of Social Security beneficiaries (10.6 million people) were disabled workers; the remaining 18% were survivors, spouses, or children of workers entitled to benefits.

Social Security Disability Insurance is an especially critical component of the program. Added to Social Security's core benefit structure during the Eisenhower era, it works hand-in-glove with retirement benefits. A young person starting a career today has a 1 in 3 chance of dying or becoming disabled before reaching Social Security's full retirement age, according to Social Security Administration data.

The retirement and disability programs also are financially joined at the hip.

Workers and employers alike contribute to the disability insurance fund through their payroll tax contributions. (Currently, 2.37% of the total 12.4% payroll tax goes into the disability fund, split evenly between workers and employers.)

The trust funds for the two programs technically are separate, but when you hear discussion of Social Security's long-range financial challenges, the two usually are discussed together. The combined Old-Age, Survivors, and Disability Insurance trust funds (commonly referred to as OASDI) are projected to be exhausted in 2034. And Congress has authorized small reallocations from time to time between the funds when one or the other faces a near-term shortfall--most recently in 2015.

Disability benefits can serve as a sort of early retirement benefit for those who no longer can work. This year, 70% of disability beneficiaries are older than 50, and 35% are older than 60, according to the Social Security actuaries.

"For most people, they are buying an insurance policy when they're paying into Social Security," says Lisa Ekman, director of government affairs for the National Organization of Social Security Claimants' Representatives, a group of attorneys that handles disability cases. "It doesn't really matter to them if they are unable to keep working due to a disability or retirement."

But that doesn't mean SSDI is easy to get. You'll see sensational headlines from time to time alleging massive fraud against the program by "freeloaders"--and certainly, some of that occurs. And, the number of people receiving SSDI has risen sharply in recent decades, but not mainly due to fraud. Instead, the causes were population growth, aging of the baby boomer generation, growth in labor force participation by women (thereby qualifying them to receive SSDI), and a higher full retirement age.

Some researchers have concluded that the business cycle affects application trends. For instance, applications jumped in the wake of the Great Recession of 2008-2010--but approval rates actually fell.

The reality is that SSDI is tough to get. In order to qualify, you must have worked at least 25% of your adult life (and five of the past 10 years); suffer from a severe physical or mental impairment that is expected to last 12 months or result in death; and be unable to perform "substantial gainful activity."

Only about 4 in 10 of all applications are approved after all levels of appeals have been exhausted--a number that has been falling in recent years. What's more, the program suffers from an appalling backlog in applications and appeals--the result of cuts to the Social Security Adminstration's budget by Congress in recent years. People filing initial applications wait an average of 240 days to find out if they qualify to receive benefits. And, in August this year, people who received determinations on appeal had been waiting an average of 627 days.

For successful applicants, the benefit is calculated using the same formula that determines retirement benefits. It is based on your lifetime average earnings covered by Social Security; if you become disabled before qualifying for retirement benefits (age 62), you will receive the full benefit that you have earned up to that point.

When you reach your full retirement age, the benefit continues under the retirement program. But the SSDI benefit formula differs in one important respect.

The formula for determining benefits starts with a calculation of your average indexed monthly earnings. The formula it takes any years of earnings that you had before you reached age 60 and indexes them for wage inflation. For a retirement benefit, the highest 35 years of wages are indexed--even if some of those are years of zero earnings. That, of course, can reduce average indexed monthly earnings.

In the case of an SSDI benefit, the Social Security Administration removes up to five of a disabled worker's elapsed years with the lowest earnings in calculating her average indexed monthly earnings. This feature reduces the effect of years of lower--or zero--earnings on benefits. That boosts their benefits somewhat; the intent here is to recognize that disabled workers have lost years of valuable work credits that cut into their benefits. Indeed, the average disabled worker benefit last year was $1,171, compared with $1,360 for retired workers, according to the agency.

The Congressional Research Service puts it this way: "For example, for a worker who becomes disabled with seven years of work history in covered employment, only the highest six years of earnings will be used for the purposes of AIME calculation (i.e. applying one disability dropout year). If the worker had 10 years in covered employment, the Social Security Administration would use the highest eight years of earnings (i.e. applying two disability dropout years)."

The difference between an SSDI and retirement benefit narrows as you get closer to retirement age. The amount you would receive is spelled out in your personal Social Security statement; these were mailed out annually until a cutback. However, the statement always is available if you have opened a free MySSA account.

Interaction With Other Insurance An SSDI award makes you eligible for Medicare following a 24-month waiting period. In many states, it also helps people access Medicaid, which can help pay for nursing or home-based care.

If you have commercial disability insurance through your employer, or you've purchased disability insurance directly, it probably requires you to apply for SSDI. And many of these policies reduce their benefits dollar-for-dollar for those who are awarded SSDI. However, some commercial policies also set a nominal minimum payout amount; payouts may also depend on the total rate of earnings being replaced by the private policy and SSDI--generally 60% of wages.

Morningstar columnist Mark Miller is a nationally recognized expert on trends in retirement and aging. He also contributes to Reuters, WealthManagement.com and The New York Times. His book, Jolt: Stories of Trauma and Transformation, will be published in February by Post Hill Press. The views expressed in this article do not necessarily reflect the views of Morningstar.com.