How much life insurance is enough?

By December 11, 2020March 8th, 2021Insurance, PFA Ponderings

“Fun is like life insurance:  The older you get, the more it costs”.

Life insurance is contrastingly both easily understood and the object of much misunderstanding.  The basic premise is simple:  If you die and have a life insurance policy, the insurance company will give money to your survivors.  Used properly, life insurance is a crucial element in a financial plan, keeping things on track financially in case a death removes a breadwinner’s income from the plan.  Mess it up, and it can be the cause of undue expense and confusion.  Worse yet, you can risk not leaving your loved ones with the means to carry on without you.

Why should your survivors get money if you die?  Well, beyond having them think more nicely of you once you’re in the hereafter, the fact is that they may need something to replace the money you were using to support them.   Life insurance takes that income potential you bring to the table and creates a pool to replace it when you’re dead.  Life insurance becomes more expensive as you age.  This is fortunate, because the NEED for life insurance is greater when you are younger!

How much life insurance you need can be challenging to calculate with precision.  Even if you take steps to run a sophisticated financial plan to identify the amount that will fill the gaps (something we happen to think is a good idea), that amount will likely go down over time, as your income increases, and your remaining working life gets shorter.

Absent the technology to make an informed decision, some rely on ‘rules of thumb’ like a multiple of annual salary.  Generally 5 to 10 times annual income is the guideline most referred to in the insurance industry.

Big expenses:  Future expenses that you currently haven’t saved up for should be considered.  This includes college tuition, the purchase of a house, and the cost of a wedding.  If these big future expenses can’t be covered without your income, life insurance should be obtained in an amount that ensures they’re covered.

Example:  Lucy and Ricky are planning on putting two kids through college at a cost of $400,000 and purchasing a house for $200,000.  They haven’t been able to accumulate much toward these goals.  They should consider covering the shortfall, in this case $600,000, with life insurance.

Bridging the income gap:  Assess how much of a household budget needs to be maintained if you’re no longer alive.  Subtract from that number the amount of income that will still come in the household when you’re gone and that’s the annual shortfall that needs to be covered.  Multiply that number by the number of years until you retire.  Keep in mind, if you have already included an amount for the ‘big purchases’, you need not include the savings toward those goals in your budget for life insurance planning – But you do need to include savings toward an ultimate retirement.

Example:  Lucy and Ricky run their home on $5,000 in take-home pay per month.  If Lucy died, Ricky would still need $4,000 per month to run the household alone.  Ricky brings home $2,000 per month, so $24,000 ($2,000 per month) annually is the amount that should be replaced with life insurance. Lucy and Ricky are 20 years from retirement, so they should multiply the $24,000 annual shortfall by 20 ($480,000) to determine their income need.  Remember to budget for retirement savings as part of the budget.

Lucy decides, given the “Big Purchase and Income Replacement method”, that she needs $600,000 + $480,000 = $1,080,000 in life insurance coverage.

Creating a legacy:  If you have a desire to leave a certain amount of money at your death to a cause or a person or persons, life insurance can be used to ensure you can still do this, even if you don’t live long enough to create a significant gift.

Term? Whole Life?  That is a question for another blog.  Suffice it to say that most income replacement risk management can and should be done with Term insurance, which you hold while you need, and get rid of once you don’t.  Other things, like leaving a legacy may benefit from Whole Life insurance where you keep it until you die, even if you live a good long life.

Is this a perfect way to figure out how much insurance you need?  No, but it comes a lot closer to fitting the bill than arbitrary rules of thumb and doesn’t create enough math to scare people off.  It’s not important to get it right to the penny, and again, even if you do, the number will change constantly in the future.  Either take the time to run the models in the context of a true financial plan – or feel free to use this simple component-based calculation.  The most important thing is that you don’t allow ‘too much math’ to lead to the neglect of this need.