Calculate Your Life Insurance Need Like The Pros
Calculating the right amount of insurance is as much art as it is science. There are a wide variety of methods developed to calculate life insurance needs, including ones that rely on rules of thumb and make it easy to come to a number. These include the DINK method (dual income no kids), the non-working spouse method, and the simple method. These methods make calculating your life insurance needs so simple you can do it in a few seconds with a calculator. But are they accurate?
These ‘easy to calculate’ methods were developed to help life insurance salespeople sell more insurance, not to help families replace their financial need. As a result, most professional planners, like Certified Financial Planners, don’t use them. The more complicated methods used by professional planners may require more work, but they are also more likely to truly provide for your family’s needs.
Needs Approach
The simplest approach for someone who isn’t a financial professional to calculate is the Needs Approach. The needs approach takes a straight-forward look at the needs of the family and estimates the amount of life insurance which would provide for those needs. The needs approach takes into account family needs for funeral expenses, mortgages, children's education funding, retirement, and other living expenses and family goals. As you go through the categories below, if you have the need then estimate the cost to those you leave behind and add it to your life insurance coverage.
While some of these needs are easy to calculate (your mortgage lender sends you a statement every month with your balance) others such as your remaining retirement funding or readjustment period needs will be harder to calculate. Even ballpark figures, though, can yield helpful insights and estimates for what would be right for your family. Calculating your need for each of these categories and adding them up will give you a good ballpark of what a financial planner might suggest for your family life insurance need.
Funeral & Related Expenses
The first thing a family needs to deal with are the funeral expenses. Even simple funerals can cost well over ten or twenty thousand dollars. On top of that will be any uninsured medical bills, estate expenses, and other costs which may come with the death.
Mortgage/Down Payment
Added to funeral expenses should be an amount to help offset mortgage costs. Your mortgage statement should provide the amount remaining on the mortgage. The mortgage balance can be split between the proportional income of each spouse to account for the lost family income. You may also wish to over-fund this category by paying off the mortgage entirely if either spouse dies. Having a paid for house can relieve a lot of financial stress for a newly-widowed parent.
Education Fund
Once you have children, an education fund should be considered as part of your life insurance needs. Discuss how much of your children’s college education costs you would like to pay for and incorporate your share of the total cost of college into your plan. Again, you can split the college funding amount between the each spouse's life insurance policy based upon your wages.
Child Care Needs
If you have children and one spouse is a non-working spouse, consider the costs of childcare and other professional household services the working spouse would need to hire. This should be added to the non-working spouse's life insurance balance. Figure the annual cost of these services and multiply by the number of years until the youngest child turns 18. Also added to the figure should be additional expenses required for caring for mentally or physically challenged family members.
Consumer Debt/Emergency Fund
If you're still working on paying down consumer debt (credit cards or vehicle loans) or building your emergency fund, an fund to pay down consumer debt or establish a family emergency fund should be added to the amount of life insurance purchased.
Readjustment Fund
The readjustment fund is created to provide a financial cushion to allow a surviving spouse to recover emotionally. The death of a spouse is devastating to the surviving spouse, who may not be ready to immediately reenter the workforce. The readjustment fund provides for additional money to allow the surviving spouse to grieve and be with family rather than have to immediately return to work. Even just being able to reduce work hours can be an incredibly important part of the healing process for the surviving spouse. Realize a non-working spouse may need additional funds for education and to help them transition into a career.
Retirement
The final piece is an amount to help fund the retirement needs of your surviving spouse. This one is the most difficult to calculate without a more sophisticated approach as it involves calculating expected social security, the number of years until retirement, your current retirement savings, any expected pensions or other sources of income, as well as many investment portfolio factors.
A good rule of thumb for those in their 20's would be 2 to 3 times your annual income less any current retirement savings. Those in their 30's you would want 4 to 5 times your annual income less your current retirement savings. For example: a 25-year old making $40,000 per year who has $20,000 in their 401(k) at work would want to add $80,000 to their life insurance coverage ($40k income x 2.5 = $100k - $20k current retirement savings = $80k of additional life insurance.)
Add Up The Total
The final step is to add up the total for each category to get a ballpark of your total life insurance need. You can also hire a fee-only financial planner to help you calculate more accurately your life insurance need. Although a life insurance agent will calculate it for you, they are paid commissions based on the amount of insurance they sell. And those commissions ultimately come out of your pocket. A fee-only financial planner is paid by you and doesn't receive commissions from anyone else. This means the advice they give doesn't have the inherent conflict of interest a life insurance agent does.
As you can see from the above categories, it won’t be hard for you to hit a half million or even one million dollar life insurance policy. Fortunately, the younger you are the cheaper life insurance is. And if you are young, in good health, and have a health exam as part of getting your life insurance, you can get that amount of insurance for $20 to $30 a month.
Other Approaches
Financial planners will also use other approaches to determine life insurance needs, although they are more difficult to calculate without proper training.
Human Life Value Approach
The concept behind the Human Life Value Approach is to replace the present value of the lost earnings the family would have received. Effectively you start with the person’s average annual earnings and subtract all the things which reduce what the family would receive. These include taxes, money spent by the deceased spouse, health insurance premiums, and other costs which are gone after death. Finally, a present value calculation is run on the remaining future earnings to determine the life insurance amount. This approach has numerous limitations including not taking into account specific family goals, other sources of income, and changes to the family spending over time.
Capital Retention Approach
The Capital Retention Approach attempts to replace the insured’s income by creating an investment portfolio large enough to then produce that income. The approach begins with the preparation of a personal balance sheet and identifying any current income-producing assets. From that you can calculate how large of an investment portfolio would be needed to generate the needed income and life insurance can be purchased to fund the portfolio. A limitation of the approach is you still have to take into account salary increases and inflation. The complexity of the approach usually requires a professional financial planner with investment management experience.
The Best Method - Comprehensive Financial Plan
The best method is having a financial planner (preferably a fee-only planner) calculate life insurance as part of a Comprehensive Financial Plan. As you think back through the previous chapters, you’ll realize how complex and dynamic your family’s finances are and how much they will change over time. As a result, it is difficult for any calculation by itself to truly come to an accurate number for life insurance needs. Life insurance should be incorporated into a holistic financial plan which includes you family’s current budget, debt, tax situation, major goals, retirement planning, current savings and investments, savings rates, and other key factors.
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Joshua Escalante Troesh is a tenured professor of Business at El Camino College and the founder of Purposeful Finance. His career provides him with a unique insight on personal financial, having been a VP at a financial institution leading up to 2008, and involved with technology and internet stock research leading up to 2000. He can be reached for comment at info@purposefulfinance.org