By JLP | December 20, 2005
This is a long post. I couldn’t think of a good way to break it up.
You see commercials all the time about how you can get $100,000 of term life insurance for $10.00 (or whatever amount it is) per month. Although that sounds good, the real question is: how much life insurance do you need? I’m going to try to address this question with this post.
It’s never fun to talk about life insurance. However, it is a necessary ingredient in a prudent financial plan. There are various methods for calculating insurance needs. I’m going to discuss a more in-depth method of estimating for earnings replacement and cash needs. I found this method in a book called Personal Financial Planning by G. Victor Hallman and Jerry S. Rosenbloom. There are many life insurance agents with computer programs who can run these numbers for you. However, it is always good to know how to compute the numbers for yourself so you know that the agent isn’t trying to sell you more insurance than you need.
Here’s the process:
Find your annual gross earnings for you and your spouse. You will want to do this computation for each of you.
Taking each person separately when both are working outside the home, estimate what percentage of gross earnings should be continued to survivors if the person were to die. According to the authors, this is usually around 70-80% because some expenses will be reduced upon death, while others like childcare will most likely increase.
Estimate what existing sources of income will be available to the surviving spouse. These may include:
- Annual earnings of surviving spouse
- Social Security survivorship benefits
- Investment income
- Pension survivorship benefits
- Other income sources
Subtract the existing sources of income found in Step 3 from the gross income desired. This will give you the deficit in the amount of annual income desired.
Convert the deficit found in Step 4 into a lump-sum amount of capital needed to meet the annual income desired. The method for arriving at this number varies from advisor to advisor. Some feel that the insurance only needs to provide for the surviving spouse until the last child is through college. Others believe it should last throughout the survivor’s lifetime. Still others believe it should provide for grandchildren. Notice that each example means drastically different insurance needs. This is an individual decision and one that should not be taken lightly. If you do meet with an insurance agent, remember that they get paid based on HOW MUCH insurance you buy. Buy what you are comfortable with and what your budget can afford.
Here’s an example of how to calculate the amount of insurance needed:
Say you find out that you need $50,000 per year in additional income provided to your spouse. Your spouse is 35 years old and you want to provide them with this income for their lifetime with any remainder going to your kids. To fnd out how much capital this would require you have to know the amount needed ($50,000), the expected return on the portfolio (3.5%, which is the expected inflation rate). Now, you simply divide $50,000 by .035 to get $1,428,571 ($50,000/.035 = $1,428,571). As long as the surviving spouse invests the insurance proceeds safely and never uses principal by spending more than the interest earned on the portfolio, the money should never run out.
Consider any cash needs at death. These include things like burial costs and any hospital bills, the establishment of an emergency fund and possibly paying off any debts. For this example we will say they need $250,000 in cash.
Combine the lump sum earnings replacement need found in Step 5 with the cash needs found in Step 6 and subtract the person’s other assets and present life insurance coverage from the total need for coverage to determine the amount of new life insurance (if any) the person needs. We will say that they currently have $500,000 in insurance through their employer and they have $200,000 in their retirement plans.
The math would look like this:
So, based on this very simple example, this couple needs approximately $1,000,000 in additional life insurance. At least by running the numbers yourself, you will give yourself some idea of what to expect when you go see your insurance agent or go shopping online.