By Neal Frankle, clarkhoward.com
Having the right life insurance policy and the right amount of coverage is the cornerstone of a solid financial plan for some people.Let’s explore this further to determine if you are one of those people who do need life insurance and if so, how much.
The big picture
Life insurance is nothing more than a backup plan. It steps up to take care of your financial responsibilities should you die prematurely. Here’s how it works: When a person passes away, their beneficiaries get a lump-sum payment. They can use that money any way they choose. Often the survivors pay off the mortgage and other debts and invest the remaining money to create a steady income. Simple.
Some life insurance agents feel that life insurance isn’t only a backup plan but an investment as well. As a result they try to sell youwhole life or universal life. While these types of policies might make sense for a very small minority of people, they are rarely a good choice. That’s because they are many times more expensive than term life and the investments they offer don’t impress.
Term life insurance offers the most coverage for the least cost, so it is usually the way to go.
Are you sure you need any life insurance at all?
Many people don’t need any life insurance at all. If you aren’t financially responsible for others you may not need life insurance. Even if you are financially responsible for other people, you may not need coverage. That’s because if your financial situation is strong enough, you may be able to self-insure.
Even if you face health challenges, you should still apply if you need life insurance coverage. The insurance industry has developed many new types of term policies – some of which you can get without even having a physical exam.
Think about expenses – not income
Many times, people take their income, multiply it by a random number, and use that calculation to determine how much coverage they need. That isn’t a terrible approach but it misses the point. Life insurance is designed to handle your financial obligations in case you aren’t around to take care of them yourself. That’s why you’ll get a much more accurate reading on how much insurance you need if you think about your cost of living (now and in the future) rather than focusing on your income.
Reverse engineer your number
The most simple and reliable way to calculate how much coverage you need is to work backwards. First, figure out what it costs your family to live each month, including monthly savings. Let’s say you spend $4,000 a month on living expenses and taxes and put away another $1,000 a month for retirement and other savings needs. That’s a total of $5,000 a month or $60,000 a year.
Let’s assume your spouse brings home $20,000 a year and would continue working if you die. Also, let’s just say you own a little rental that brings in $5,000 a year net profit which would continue bringing in that cash even if you meet an untimely demise. That being the case, your family is going to need to find another $35,000 to pay the rest of their expenses if you die.
Now we’re ready to do a little math. Take that $35,000 (which is the annual shortfall) and divide it by 4% to determine how much capital would be required to earn $35,000. Why divide by 4%? Because we are going to assume that your survivors could earn 4% on the money over the long run after you die.
It’s true that the bank isn’t paying 4% right now, but who says your family will stick all the insurance proceeds in the bank for the next umpteen years? And who says rates are going to stay this low over all that time? Nobody. Assuming your family invests prudently over the long haul, a 4% return is very reasonable – even conservative.
If you do that math, you’ll come up with $875,000. That’s the amount of money your family will need to invest in order to generate $35,000 a year if they could invest at 4%. Is that the amount of insurance you need to buy? No.
Add to this $875,000 any debts you want to pay off if you die. For example, let’s say you have a mortgage of $200,000 and other debts of $25,000. If we add these three numbers together we get $1,100,000. If we keep things very simple and don’t have excess savings, that’s the amount of life insurance you need. If you have a solid financial plan in place, you should probably buy $1,100,000 term insurance that would last until you retire. In other words, if you are 45 today and plan on retiring at 65, a 20 year term policy might be the ticket – again, assuming your financial plan was strong.
What about other expenses like college education, home repairs, replacing old automobiles and travel? In a perfect world, your spending and saving number already includes these expenses. But if you have some large outlays in the future that you haven’t been saving for, it’s best to add those costs into your number as well.
What about Social Security and pensions?
The exercise above tells you how much money you’ll need in order to invest at 4% and keep your family afloat up until your planned retirement age. Once your survivors start receiving Social Security and/or other retirement income, they won’t need as much income as they did before. And since they’ll continue getting the income from the insurance proceeds on top of receiving Social Security, they will have more income than they may need.
You can get fancy and model that in to your calculation and reduce the coverage you buy but we’re trying to keep it simple. It’s true that our approach might overstate your need for life insurance, but believe me, your beneficiaries aren’t going to complain. If you have money in your retirement accounts you should ignore it for this calculation. That’s because it’s earmarked for retirement – not current living.
What about the impact of inflation?
The younger you are the more you have to be concerned about inflation. Even modest increases add up. That means that your survivors are going to have to come up with more and more money just to maintain their current standard of living as the years go by. The good news is that doesn’t have to be a problem.
If your family invests prudently, they should be able to withdraw 4% of the proceeds each year and bump it up annually to cover the costs of inflation. This usually means investing in a balanced approach to avoid taking undue risk but continuing to grow the money at the same time.
In order to determine how much life insurance you need, start by figuring out how much you contribute annually towards your family’s living costs. Take that number and divide by 4%. Then add other big ticket expenses that your family will need to pay for down the road and subtract out any savings you have that isn’t targeted for other purposes.
This calculation isn’t exact and it doesn’t have to be. We’re dealing with future costs and it’s impossible to be certain what those costs really are going to be. But this exercise is important nonetheless. And it’s a lot better than guessing or ignoring the subject completely.