How Much Life Insurance Is Enough?
How Much Life Insurance Is Enough?
By Ronald J. Pawlikowski, CLU
I have previously opined (see The 10 Biggest Mistakes People Make When Procuring Life Insurance) that the most egregious mistake individuals make in procuring life insurance is not getting enough. So the obvious question is, “How much is enough?” The short answer is “a lot more than you think!”
The thing I like about life insurance is that there is no need for it unless you care about someone. Think about it. If you don't care about someone, what motivation would you have to make their life easier when you’re gone? So, assuming the requisite care is present, let’s tackle the problem of determining an appropriate amount. (Notice I said an appropriate amount, not the correct amount. Despite what the pundits at Consumer Reports, Money, et al say, there is no correct amount, because there are just too many variables.)
The primary purpose of life insurance is to replace an income and/or retire a debt. The retiring the debt portion is much easier to determine than the replacing the income portion. You must insure the entire debt, and can decrease the coverage as the debt decreases.
A simple method to compute income replacement is to capitalize earnings. If it costs $5,000 per month to live your lifestyle, $1,500,000 would be required to generate that amount at a 4% after tax rate, $1,200,000 at 5%, and an even $1,000,000 at 6%. If your lifestyle requires $10,000 per month, just double these numbers. See, it is a lot more than you thought!
When using this method, you don’t have to calculate retiring debt, because your debt (mortgage, car loan/lease, credit cards etc.) is being amortized by your monthly payments included in the amount required to finance your lifestyle.
This method does not provide for college costs, unless your monthly lifestyle number includes an amount that is systematically saved/invested and is calculated to fully fund all future educational costs. If you are not saving a monthly amount intended to fully fund your children’s education, you need to make an additional calculation. Determine the current tuition at a school your children are likely to attend, apply a reasonable inflation factor, and then compute the present value of that lump sum and add it to the total amount.
The most frequent criticism of this method is that it over estimates the amount of life insurance required for two reasons. First, it doesn’t take into consideration any social security payments for which survivors may be eligible. True, but with the burden that social security system is currently under, isn’t it possible that survivor benefits might be reduced before retirement benefits?
Second, it potentially provides for an infinite income stream, provided only the interest is spent. Again, this is true, but what is the alternative? If you are 35, you could say that your spouse has a life expectancy of 50 years and calculate the amount that would be required to provide an income for only that time frame. But what if your spouse out lives life expectancy by 5 years? 10 years? 15 years? Remember, you are procuring life insurance because you care about someone. If you’re going to make a mistake, it is much better to err on the conservative side.
Another method to determine an appropriate amount of life insurance is to have an economist estimate your “human life value.” A firm called Litigation Analytics, Inc. does just that. They are expert witnesses in wrongful death suits, and estimate the foregone earnings of the deceased to help determine the amount of the award. You can check out their website at www.humanlifevalue.com. Their method will also arrive at an amount that will probably be higher than you initially estimate.
It is frequently asked if accumulated assets can be used to reduce the amount of life insurance required. Unless the income from those assets is currently being consumed, I say no. Those assets are being accumulated for a purpose (retirement, education, etc.) and that purpose won’t pass with the insured.
This ties in to self insuring. I don’t think it is prudent. Look at it this way. Do wealthy people insure their assets? Of course they do. Why? Couldn’t they replace that $100,000 necklace if it was lost or stolen? Of course they could. They insure it because it makes economic sense to do so, just as it makes economic sense to insure your life if you care about someone.
A non-smoker’s policy issued by a quality company will yield 5-7% (depending on underwriting classification and policy type) after-tax if the insured dies at life expectancy. That is not a terrible yield for such a conservative vehicle.
In closing, you need to remember two things. One, if you care about someone who depends on you financially, you in all likelihood require some amount of life insurance. Two, that amount should be estimated in a very conservative manner.