How to Buy the Right Amount of Life Insurance

Most Americans ignore what insurers tell them about the amount of life insurance to buy. That’s probably a good thing for them. Even so, most people own the wrong amount of insurance. They ask the wrong question and get the wrong answer.

The insurance industry generally recommends buying life insurance benefits equal to seven times the individual’s annual income. It is not clear how the recommendation was developed, which probably explains why most people ignore it. A recent study funded by Allstate found that the level of life insurance owned varies around the country. People in Pittsburgh generally have life insurance equal to three times their incomes. People in San Diego buy 5.4 times income, which is the highest multiple in the country.

A multiple of income is the wrong way to buy life insurance. Your level of income doesn’t have a lot to do with your life insurance needs.

Life insurance is meant to pay expenses that result from your death or that your future income was intended to pay. The amount of your income today has little to do with the right amount of insurance to buy.

Consider two people with identical incomes. One person is older, is essentially debt free, has accumulated assets beyond his needs, and his children are grown and established. His wife is the only real dependent in the family. The other person is younger, has accumulated few assets, and has a mortgage and a couple of young kids. His spouse stays home with the kids.

The first person might not need any life insurance. There are no debts to pay, and his assets might be enough to maintain his widow’s standard of living. He might, however, need life insurance to pay estate taxes or choose it to leave an additional inheritance for his heirs.

The second person would leave behind significant debt. There also are future obligations his income was expected to fund, such as family living expenses and college expenses for the children. In addition, his spouse might have to get a paying job. She might not be able to earn as much as he is, plus she likely would incur child care expenses and other costs to be able to take a job.

That’s why your current income should not be the starting point. There are several layers of obligations that might need to be covered by life insurance, and each should be considered separately. Then, total the specific expenses, debts, and goals that are expected to be covered.

Start with expenses. Make a list of the annual household expenses. Subtract expenses that are likely to decline if you are gone, and add any expenses that might be incurred or increase as a result of your death, such as child care. Also subtract any that will be covered by a continuing source of income, such as Social Security Survivor’s Benefits, your spouse’s income, and employer payouts.

Subtract the amount that can be covered by income or draw downs from your investment portfolio.

The total is the annual expenses that need to be covered by life insurance.

How much life insurance is required to cover these expenses? One approach is to assume that only income from the life insurance benefits is used. Suppose the annual expenses are $20,000 and you anticipate the proceeds will be invested to earn 5%. Your survivors will need $400,000 to generate $20,000 per year at 5%. You might want to buy a little more coverage to maintain the purchasing power after inflation.

Or you can assume that the principal can be spent over time. In that case, you’ll need annuity tables or a calculator with an annuity function. Estimate the number of years the payouts will need to last. If you want the $20,000 to be paid for 20 years, you will need about $250,000 of life insurance.  Again, you might want to buy more insurance to cover inflation. Your beneficiary can either choose to manage the insurance proceeds or can use them to buy an insurance annuity.

The next layer of insurance needs includes lump sum expenses. These might be a mortgage and education expenses for the children or grandchildren. There also are death-related expenses such as the funeral.

These are easier to compute. You simply add the lump sums that will be due and buy the appropriate amount of life insurance.

The final layer is estate taxes and charitable gifts. Work with your estate planner to estimate the amount of your estate taxes, then decide how much to pay with life insurance. Charitable gifts usually aren’t funded with life insurance, but it is an option.

Finally, decide which layers to cover with term life and which with whole life or other permanent life insurance. The insurance industry generally advises lumping all these expenditures into one insurance policy. But some are permanent needs and others will expire over time. For example, your children’s education and your mortgage are not continuing obligations. If your youngest child is eight, a term life policy of 15 or 20 years should be sufficient. The living expenses of survivors also might be temporary.

Estate taxes, charitable gifts, and the needs of a disadvantaged child might be permanent insurance needs.

A web site with a calculator that helps you compute the insurance need using this method is www.life-line.org.

After computing your life insurance needs using this method, it might be interesting to see what multiple of your income the insurance benefit is.