Most of you have either too much or too little life insurance. It’s not your fault. Ask 10 financial professionals to estimate your life insurance needs, and you’ll probably get 10 different answers. But insurance premiums are too expensive for you to be buying excess insurance, and life insurance is too important for you not to have enough.
Most people unfortunately buy life insurance based on a formula. The most common formula is to buy life insurance equal to five times your annual income. Some advisers increase the multiple to seven or even 10 times annual income. But the formula doesn’t work well. Single people often don’t need any life insurance. And a family with five kids probably needs more life insurance than a two child family.
A better approach is to determine your individual need for life insurance. Start by listing all the expenses that currently are paid with your income and that would continue after your death. These include family living expenses, mortgage and other debt payments, and education for children or grandchildren. Then list expenses that would be incurred as a result of your death, such as funeral expenses, estate taxes, and funding for any business buyout agreement you might have.
Now make a list of all the assets you own that will be available to pay these expenses and any sources of income that will be available to your survivors. For example, you might have investment assets and employer-paid life insurance. And don’t forget Social Security survivors’ benefits that might be available to your spouse or children.
Decide which of the expenses you want covered by life insurance and which you want covered by other assets and income. For example, some people expect part of their estate to be used to cover estate taxes, while others buy life insurance to pay the taxes. Some people want a spouse’s living expenses to be covered for the rest of his or her life, while others expect that a surviving spouse will replace the income or reduce expenses within a few years.
The result is your net insurable needs. But don’t go out and buy one life insurance policy for that amount. There are a few more adjustments you need to make to ensure you purchase the right amount of life insurance.
Divide your net insurance needs into two categories. One category is of expenses that will end at a certain point in time, such as mortgage and debt payment, tuition expenses, funeral expenses, and estate taxes. Living expenses for survivors also might be included in this category if you expect that your survivors will adjust to your lost income after a period of years. The other category is expenses that will continue more or less indefinitely, such as your spouse’s living expenses if you want insurance to cover those indefinitely.
The expenses that will end on a certain date can be covered by term insurance. This is cheaper than permanent life insurance (such as whole life) and your insurance premiums will end when the need for insurance ends. The other expenses can be covered by a permanent insurance policy.
There’s another question you should ask before deciding how much permanent insurance to buy. Some people want their survivors to be able to maintain their standard of living by using only the interest and income from the insurance proceeds rather than dipping into the principal. That leaves the principal available for emergencies and to cover inflation. If that is how you feel, you have to buy enough insurance to generate the desired annual income. For example, if you want to generate $50,000 of annual income and anticipate interest rates will be 5%, you should buy $1,000,000 of life insurance.
But if you want the survivors to spend the principal as well as income, then you have to estimate the rate of return that can be earned from investing the insurance benefits and determine how long you want the money stream to last. Using these figures you can do a present value of an annuity calculation to determine the right amount of insurance to buy (or if your insurance agent make the calculation for you).
If you are retired, the kids are established on their own, and you have accumulated enough assets to provide for your spouse (or you don’t have a spouse), you might not need any life insurance. But if you are carrying a lot of debt or have a valuable estate that you don’t want broken up to pay for taxes, you might need a fair amount of life insurance. That’s why it is important to analyze your individual insurance needs instead of using a formula. Two individuals who are the same age and have the same income might have very different insurance needs.
If you are underinsured after doing this analysis, you can buy more insurance. What if you are overinsured? I’ll give you some tips on how to take advantage of excess insurance in next month’s issue.