Following up on the previous blog post which discussed the various types of Life Insurance we now switch our focus to the question of how much life insurance do people really need?
Fortunately, I have found that most people I have encountered have some sort of life insurance coverage. That being said, unfortunately I also find that a high percentage of people don’t have an adequate amount. As discussed in the previous post, life insurance in its most basic definition is intended to replace the income of the person who has passed away. The truth it is it is more nuanced than that and can depend on your family/relationship circumstances, income and age among other things. One good thing about life insurance is that the proceeds are tax free for the beneficiaries so taxes are not a much of a factor in these calculations. I’ll try to cover these different situations below.
Method 1 – Cover basic expenses
This would be for someone who is just looking to make sure that the survivors have enough to pay final expenses including the funeral and any legal fees that might arise from probate or estate settlement. This is best for someone who is young and single with no dependents that are reliant on their income. Even in this situation it might make sense to throw on a year or two of income replacement so that family can replace any of the income they might lose as a result of time off they have to take to deal with their loss.
Method 2 – Basic rule of thumb is 8-10 times income
The most basic calculation for how much life insurance is needed is roughly 8-10 times your annual income. This can be a good solution for younger families or couples who may not be at a point where they can calculate a more accurate amount of their actual needs. This should allow the surviving spouse to at least get a decent lump sum to use for financial stability.
While this approach might suffice in lieu of a more detailed calculation there are some obvious flaws. One, it doesn’t take into account potential income discrepancies within a couple. Is this to say that parent who stays at home needs no life insurance? Of course not. Is 8 years actually enough when there are young children involved? Maybe not. Is 8-10 years necessary for someone who is young and single or for a couple in their 50’s with grown children? Maybe not.
Method 3 – Calculate lump sum needs and replacement income.
This method calls for determining the proper amount of life insurance based on the goal of paying off lump sum items and then determine what the remaining income needs are. For instance, if a couple has a mortgage in the amount of $300,000, a car loan for $25,000 and credit cards in the amount of $10,000. This is $335,000 in lump sum items that would eliminate debt and major payments for the surviving spouse. In addition, they may want to consider a goal for setting aside money for the children’s education or a aiding in retirement savings. Let’s say they want to save $40,000 for education and $250,000 for retirement savings. This is a total of $625,000. By having all of these needs taken care of the surviving spouse only needs to worry about meeting certain ongoing living expenses. Now let’s say those living expenses total $4,000 per month and the surviving spouse makes enough to cover $3,000. That leaves $1,000 per month for say 20 years or a total of $240,000. The combined total of lump sum and ongoing income needs can be covered with $865,000 of insurance.
This method works pretty well for families and couples, especially those who aren’t quite as young and are in a position to put a dollar figure on some of their financial goals. This also allows flexibility for couples where there is a discrepancy in their income levels or in the case of a parent who stays at home. The debt and financial goals can still be met with the insurance and the amount needed for ongoing expenses can then vary depending upon the survivor’s income level. It also allows flexibility for the surviving spouse to maybe take a different job that may not pay as well if that is what might be best for the remaining family members.
Method 4 – Calculate net present value of income
Admittedly this technique is a little technical and not one that is very user friendly. This method calls for taking projected income and discounting it based on an assumed rate of return. For example, if you want to replace $100,000 of income for 30 years and assume you could conservatively earn 4% on the amount you received year 1 would be worth $100,000, year 2 would be worth $96,000, year 3 calculates out to about $92,450 and so on. In this case, replacing 30 years of income at a 4% return would require roughly $1,800,000.
This has most of the same limitations as method 2 with a few differences. One, by knowing the number of years you want to replace income you have a better chance of the funds lasting the proper number of years. Two, this isn’t as easy to calculate. Determining 8-10 times your income is pretty straightforward but discounting to a present value is something that many people would need help calculating. Finally, this requires you to use a reasonable rate of return. If the rate used is too high or too low the calculation can be off.
Method 5 – Hybrid of methods 3 and 4
This is the most accurate method but also by far the most complex. In this method we will look at three separate buckets to determine lifelong funding needs. The first is the lump sum items as in method 3. The second bucket is ongoing income needs also as in method 3. Finally, we will consider the amount required to fund retirement.
What makes this method different is how we calculate the number for each of these buckets. For ongoing income take the expected ongoing annual expenses, which will most likely change from year to year based on different circumstances such as new obligations arising or having others go away (an example might be childcare expenses being reduced once kids are in school or general expenses being reduced once they go to college) and reduce this by expected ongoing income. This results in the net amount needed for ongoing income. Finally, we calculate what amount you would need today to meet this need. This is done by assuming a rate of return that would allow a lump sum received today to grow to meet the calculated need.
Essentially the same thing is done for the lump sum items. Add them up and calculate a present value for those items. There is no income offset to take into account for this calculation.
Finally, for the retirement income, you will need to determine your expected annual expenses and increase for inflation then subtract anticipated social security and pensions. This multiplied by the number of years gives you your retirement income needs. Next, calculate what you expect to have in retirement accounts at the time of retirement and subtract this from the retirement income needs. This gives you the net additional funds needed for retirement. Again, calculate the present value of this net amount to come up with the amount needed today to fund this item.
By adding up the totals from these three buckets you have the amount needed for insurance today to fund all of these buckets. This is a complex and lengthy calculation which many people may not want to undertake and it requires having several future numbers like social security and retirement expenses that many people may not know.
Method 6 – Permanent insurance
The methods listed above were primarily focused on paying off lump sum items or replacing income and these are more closely aligned with term insurance. While the same calculations can be used on a permanent life policy, these policies can also be used to serve a different purpose such as funding a specific goal or a trust. In these cases income may not be a factor but instead you may need to determine the value of what you are trying to fund.
Summary
While no one wants to deal with the aftermath of a loved one’s death, life insurance helps at least ease financial concerns for the survivors when they are already dealing with so much else.
Determining the proper amount of life insurance can be a bit tricky and the amount of life insurance you need will vary over time. What you calculate as your need at age 25 will vary greatly from your need at age 35, 45, 55 and 65. Work with a fee only fiduciary financial advisor to help determine the right amount for you and your family especially as life events may trigger a need for a different amount of coverage.
Thank you for reading this latest blog entry. I hope you found this informational and can find something to use in your own life. The next blog topic will continue with insurance but will change the focus to home owners insurance. As always, if you have any questions feel free to reach out to me at info@7thstfinancial.com.