What's the reason for life insurance?
The purpose of life insurance is to provide for the financial needs of your dependents in the event of your death. We often know why we need life insurance, but what is often unclear is how much? Life is so unpredictable and complex that it is impossible to know exactly how much you will need and when. Amidst all of the "what ifs", what can we do to find a coverage amount that allows us to sleep well at night knowing that our family is covered?
First, Do I Need Life Insurance?
As a rule of thumb, if you're single and do not have any dependents, you typically don't need life insurance. The criteria for necessity of coverage can be addressed by a simple question:
Will my passing have an adverse financial impact on my dependents?
The question may be short, but it should not be pondered lightly. Admittedly, this question does not cover every single situation that would precipitate the need for life insurance (you can find a more comprehensive list here), but the question does create the proper framework for thinking about life insurance.
How Much Do I Need?
There are countless ways to determine how much life insurance you need. I'll highlight the most widely used methods, but I will only walk through an example of my favorite method. If you would like to use one of the other methods listed, there are plenty of online calculators available for these.
#1: Human Life Value Approach
In short, this method estimates the present value of all of your future earnings until retirement, minus taxes and your individual living expenses. This method asks the question:
How much will I make?
I don't like this approach as much for several reasons:
- It assumes that your earnings will be on a constant glide path for the remainder of your working life.
- It ignores the specific needs of your family. It seems like the equivalent of going grocery shopping and then getting up to the register and handing the cashier a $100 bill before any item is scanned and they ask you, "Do you know if this will cover everything you have here?" And then you just shrug your shoulders.
- It involves time value of money calculations and income projections that you almost have to be a financial planner to figure out. Just because the process is complicated doesn't make it a bad method, but I would rather spend the time and calculation thinking about specific survivor needs than trying to come up with a clever estimation of what your income will look like.
#2: Earnings Multiplier (Easiest)
This method is by far the easiest and most widely adopted. Most people refer to this way as the rule of thumb. For this approach you merely multiply your gross income by 8 to 12, depending on what you feel your dependents will need. No reductions for taxes or living expenses, just plain and simple multiplication. Some people even tack on another $100,000 for each child's college. This method answers the question:
What is the least amount of time I can spend thinking about life insurance?
Reasons I don't like this approach:
- It's lazy.
- Just like the method above, it doesn't take into account the specific needs of your survivors.
- It usually results in under-coverage for people with a lot of debt and/or children and over-coverage for people with a small amount of debt and no children.
#3: Needs Approach (The Tailored Suit)
This method is my personal favorite because it is logical and directly addresses the needs of your dependents. Think of it as the tailored suit method. The approach is just as it sounds, each dollar of coverage is specifically geared towards a certain family need. This approach asks the question:
How much will my dependents need?
There are three categories of needs that should be addressed:
- Immediate Needs:
- Funeral costs
- Estate taxes (if applicable) and settlement costs
- Debts (credit cards, outstanding bills, car loans, etc.)
- Remaining mortgage
- Outstanding alimony
- Ongoing Considerations:
- Family living expenses (How long will it take them to transition to living without your income?)
- Private schooling cost (if applicable)
- College education (FUTURE cost, not today's cost)
- Child support
- Childcare cost
- This is where the hard part comes in. You have to not only think about short-term coverage, but you have to keep in mind the long-term picture and what kind of quality of life you want for you family.
- Special Needs: Do you want to leave something to a charity? How about something extra for your spouse or your kids? How will your spouse's retirement be without you? It's important to think about these things in terms of the amount of coverage and the beneficiaries you select on the policy.
The only thing that I would add to this method is that it is very important to also consider your net worth and savings. If you have a portion of assets or savings that would be able to be used by your dependents to cover some of their needs, it's important to factor those in as well.
So How Do I Find My Number?
- Income Replacement: Multiply your income by the number of years you would like to replace your income (NOTE: Keep in mind that in this calculation you are not factoring in taxes or living expenses for yourself, so don't go crazy and pick a huge number. Try to keep your multiplier under 20). This should be based upon how long you think it would take your family to transition from relying on your income. You may have reason to believe that they would never be able to go without your income; if so, pick a higher multiple.
- Needs Analysis: Take your number that you got from part 1 and add: funeral costs + estimated estate taxes(if applicable) and settlement costs + debts, including mortgage + future college costs + other needs. If you are a stay at home parent, it is important to include the cost of childcare services that would be required if something were to happen to you.
- Adjustments: Subtract: current college savings + current savings + other liquid assets + other life insurance in force.
How about an example?
Meet Noah and Holly. Noah, 30, makes $70,000/yr. at his job and Holly, 28, is a stay-at-home mom, taking care of their 2 kids, Lincoln and Nora, ages 5 and 3. They have a mortgage with a balance of $175,000, a car loan for $15,000, and credit card debt with a balance of $4,000. Noah has $50,000 in group coverage through his employer. They have $15,000 in savings and $10,000 in each of the kid's college savings accounts. They also have $10,000 in a general investment account.
Noah seeks out a 20 to 30 year term policy to cover his family until the mortgage is paid off and the kids are through college. His calculation on the amount he needs would look like the following:
- He takes his income of $70,000 and multiplies it by 8 years to get $560,000. Noah and Holly have discussed that if something were to happen to him, Holly would make the transition to looking for employment to supplement future income for the family going forward.
- Noah next adds the following: $10,000 for funeral costs + $150,000 for each child's future college + $175,000 for the mortgage + $15,000 for the car loan + 4,000 in credit card debt for a total of $344,000. He then adds the total of the first part to get $904,000.
- Noah also adds an additional $100,000 to cover child services until the kids are old enough to be at home alone so that Holly may work.
- Noah then subtracts his current coverage through work of $50,000, the $20,000 in savings, along with the $20,000 in the college accounts, and the $10,000 in their investment account to reach a total of $804,000.
- Noah and Holly determine that they will look for a 30-year term policy for $900,000 for Noah.
What about Holly? Her calculation would look something like this:
- She determines that, if she were to die, it would cost about $100,000 from now until their oldest child would be old enough to be at home alone with their youngest.
- She then adds all the debts and makes the same adjustments above to get to a total number of $344,000.
- They determine that they will look for a 20-year term policy for $350,000 for Holly.
It is important to periodically reassess your life insurance coverage to make sure you are covered as you progress through life. Has your income drastically increased? Any major changes to your level of debt? One of my favorite features of term insurance is the ability to ladder policies on top of each other to reach the desired amount and length of insurance at the lowest cost. There is hardly ever a one-size-fits-all solution to life insurance. It is important to give serious thought to the amount and length of coverage. Talk to your financial advisor for more specific and tailored solutions to your situation.