Part 1 of this series explained the financial lifecycle and provided a general overview of life insurance. In Part 2, I’ll discuss the factors that determine insurance needs and provide an example calculation.
Whew! Now that we’ve gotten past the details of the financial lifecycle and the types of life insurance let’s take a look at how to actually calculate life insurance. First, we want life insurance proceeds to cover the immediate costs of the individual’s funeral, such as funeral home costs, burial costs, travel costs, and short-term lost income if needed. These costs can vary greatly. No idea? $20,000 is a good starting point.
Covering Liabilities and Obligations
For this calculation, we want to include any loans that could result in collections against survivors or the insured’s estate. Such loans can include mortgages, auto loans, credit card payments, etc. Some loans, like federal student loans, are discharged upon the death (but then result in additional income taxes) of the individual, so some analysis is required here. The amount of insurance required to cover these obligations should include any remaining principal and accrued interest.
Future Income Needs and Financial Goals
Insuring future income requirements often contributes the highest amount to the life insurance needs calculation and is unique to each individual and family. For example, if both spouses have high earning potential, the loss of one income could be overcome by the surviving spouse, especially if the family is debt-free. On the other hand, maybe one spouse is the primary caregiver to children and years out of the workforce will make it more difficult to care for children and while also replacing lost income.
Additionally, we must determine how long we need to replace lost income. In the first example, the surviving spouse may only need a few years of additional support before being able to support him or herself. In the second example, the surviving spouse may need ten years, 20 years, or a lifetime of support. For ten years of support, we could simply multiply the annual need by 10. For 20 years, multiply by 20. Beyond ten years, inflation starts to take a real bite out of purchasing power, assuming historical inflation rates, so a portion of any benefits would need to be invested. Certain annuities may be a suitable alternative, as well. To replace income after 20 years, we start needing to look at multipliers of 25 to 30 times the annual income requirement. At the 25-year mark, we will likely need at least $100,000 to provide the same lifestyle as $50,000 does today once inflation is factored in. Yes, these numbers can be quite large.
Beyond income, we should account for future financial goals, education being the foremost of those goals. If the plan was to use future income and investments to pay for a college education for children, then the estimated cost of that education should be added to the insurance benefit amount, discounted for a reasonable investment return on those funds.
Let’s look at our stereotypical John and Jane Doe for a helpful example. Both are 30 years old and they have two children. John makes $50,000 per year and they just bought a house for $200,000 with a $150,000 mortgage. Jane worked previously but quit to care for their children full time. They expect to send their children, ages 5 and 7, to college when they turn 18 and expect to pay $40,000 per year per child. The college expenses are equivalent to $170,000 today discounting for a 6% rate of return on invested funds. Between credit cards and auto loans, the family owes another $20,000.
So far, the Does have $170,000 in debts and $170,000 in future education liabilities for a total need of $340,000. Additionally, while John makes $50,000, the family believes that if John passed, Jane could work part-time while still caring for the children and live off of $35,000 per year from insurance proceeds until both children have left for college, 13 years from now, after which she will be able to support herself. $35,000 for 13 years equals $455,000. If we adjust for 3% inflation, Jane will need $50,000 in that 13th year to maintain an equivalent living standard, making the total need equal to $550,000.
Add $550,000 in income needs to the previously mentioned $340,000 plus $20,000 for final expenses and we arrive at a need for a $910,000 insurance policy on John with Jane as the beneficiary. But what if Jane passes instead of John? While she brings in no income, she contributes immense value to the family in caring for the home and the children. Valuing her contribution in monetary terms can be difficult, though. We can look at the costs of daycare when school isn’t in session and the cost of after-school care when it is in session. Also, how much do Jane’s efforts contribute to John’s earnings power? If he has to divert time and energy from his employment, could his income potential suffer? We can use estimates from John and Jane along with information on local daycare costs to develop a potential benefit amount for Jane’s life insurance policy. Let’s say we calculate this value as the equivalent of $20,000 per year until both children have left for college. Adjusting for 3% inflation, the benefit would need to be $315,000.
We can proceed from that point or also add some of the family’s other obligations Jane’s policy, such as debts or the cost of college education. Let’s assume that the weight of funding those obligations falls to John’s future income. As a result, John would get a $910,000 policy and Jane a $315,000 policy with each other as beneficiaries.
Structuring the Policies
So far, we have answered the question of how much John and Jane Doe need in life insurance. Unfortunately, even with my straightforward example, too many additional considerations exist to describe each one. I will cover a couple of examples, though. Term life insurance, which I explained in Part 1, is both the least expensive form of insurance and is available for varying lengths of time.
One approach would be to start with a separate term insurance policy for each need. For example, to provide insurance coverage for the education goal, John could take out a term policy on himself with a benefit of $170,000 that lasts for 15 years. As their second child will have already left for college at that point, the need for insurance ends for that financial goal. John could add the $550,000 income replacement benefit to this policy, as well. John would then buy another $170,000 policy to cover their debt load for the amount of time projected to pay off the debts. Jane would take out a 15 year, $315,000 policy to get John to the point where both children will have left for school.
Perhaps, for simplicity’s sake, John buys a $910,000 policy for 30 years, and Jane buys a $315,000 policy for 15 years. We’d definitely compare the different options to select the one with the lowest overall cost and most convenience for the family.
It’s important to remember that my example is overly simplified and stereotypical. Every person and family will find their situation unique and must conduct a thorough analysis of their own needs.
Any reader can see that I favor term life insurance. As I stated before, it’s the most cost-effective form of life insurance. Often, permanent life insurance is so expensive that an individual or family chooses a lower amount of insurance, leaving them underinsured. If a person dies unexpectedly while underinsured, the family will be in financial difficulty. Furthermore, if a family stays dedicated to their financial plan, life insurance in significant amounts will be eventually become unnecessary, negating the need for permanent insurance. Through saving and investing, a family’s assets will be sufficient to care for the survivors after the term policies expire. In fact, the huge cost savings of term insurance can be invested for much higher long-term returns. Permanent life insurance certainly has its place but is often a more expensive and less effective solution to many life insurance needs.
Command & Signal
After looking at the major factors that go into calculating life insurance needs, you should be armed with enough information to determine if you have sufficient coverage. If you need to purchase life insurance, a quick internet search will help you find online options and agents in your area. When you talk with someone about insurance, remember that life insurance is INSURANCE first and foremost. It’s not a primary investment vehicle. Feel free to reach out to me with questions regarding your specific situation.
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