Monday, May 10, 2010

How Much Life Insurance?

I would be willing to bet that most people either have too much or too little life insurance. Before you read this post, what’s your gut feeling about the level of your life insurance?

I also want to note that I don’t sell insurance, am not affiliated with any organization that does, and frankly couldn’t care less who you buy insurance from. I’m only interested in helping you understand how to determine the right amount.

Term Life insurance (the pure form, not with some accidental death and dismemberment benefit and not where you are investing in the policy by paying more than for pure insurance) only pays off if you die. Life is a binary proposition. You are either alive or you are dead. (Again, we’ll ignore the missing person cases where things are in limbo for a few years.)

Here’s the thing: actuaries (and I used to be one of them) are pretty adept at estimating what percentage of a large group of people will die at each age. What they can’t do is tell which ones. (Although there is a rumor some Sicilian actuaries have the inside track – it’s a joke—pause for groans.)

Dying, however, is not necessarily a financial risk.

I am an example of someone who does not need life insurance. I have sufficient assets to cover all my debts and take care of funeral related expenses. My children are grown and no one is counting on me for their living expenses, or college education. (At least they shouldn’t be.) In fact, some charitable organizations would benefit from my death.

I could purchase life insurance to increase the size of my estate, but if I do, I’m not buying insurance; I’m buying future gifts for my favorite people or charities. I’m making a choice to invest in a bet on when I die rather than give them the money directly for them to invest. That’s not eliminating any financial risks of my untimely death.

When I first started working, I was in a similar position regarding life insurance to where I am now. The modest life insurance policy I got as a benefit from my employer more than covered my obligations. However, as soon as I had my first child everything changed. With that blessed event, my death was no longer just my bad fortune. My death would eliminate a future income stream that I expected to use to take care of my child through college and take care of my wife during the time she couldn’t earn full wages because she was taking care of our child. The ante increased with child number two.

I think at that time my employer-provided policy was three times my pay. It was woefully inadequate. To do a quick estimate of how much life insurance you might need, figure out a year’s worth of living expenses for all your dependents. Multiply that by the number of years you need to support your dependents and then add on college expenses (if you were planning on paying for them), credit card debt, student loans, etc. (not your mortgage payment because that should be part of your annual support number.)

Fancy Dan investment folks will want to develop present value numbers that recognize the time value of money and future cost increases and all kinds of stuff to make your head spin.

This isn’t an exact science and the method I’m suggesting implicitly assumes your dependents can invest the money to earn the same rate costs will increase in the future.

Here’s a simplified example:

Alice and Joe have two children, ages 8 and 6. They both work and each earns $40,000 per year. After taxes and savings they spend $60,000 per year or $30,000 from each paycheck. If either of them dies, they want the surviving family members to maintain their same lifestyle.

It will be 10 years before child 1 is out of the house and each year the family will be $30,000 short, for a total of $300,000. The second child will be in the house an extra 2 years at (say) $6,000 a year. (An extra $12,000). You want each child to attend college and you’d like for them not to have to take student loans since you won’t be there to help them out afterward. If you die, private college may be out; but even at a decent public college, tuition, room and board, a car, books, fees, etc. adds up to a bundle. You figure $20,000 per year (so $10,000 for each parent) for eight years (Totals $80,000).

Grand total = $392,000. Put another way, each parent should be carrying insurance of almost ten times their gross pay.

What other things might you consider in determining the life-style risk? If the surviving parent will have to cut back on employment to take care of children, life insurance will have to pick up the slack. You may be subsidizing elderly parents and need life insurance to cover that need.

You know your personal situation better than I. The good news is that pure term insurance, guaranteed renewable for 10 or 15 years is very affordable. A 35-year old healthy male can get a $500,000 policy for a little over $20/mo.

The internet has lots of calculators to help you define how much insurance you need, and can also be used to price insurance. I suggest you go explore them. Maybe in a future post I’ll check a bunch of them out and let you know which ones I like.

So, do you have the right amount of life insurance?

Next up, different kinds of Life Insurance.

~ Jim

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