Life Insurance 101 – Part 3: How much life insurance do I need?

In Part 1 of this series, I explained why people need life insurance; in Part 2, I explained the basics of “how insurance works.” A question that people always have is, “how much life insurance should I buy?” There are various guidelines for estimating how much life insurance one should buy. Alas, they usually lead to the wrong answer.

Life insurance is unique among insurance products. With most forms of insurance, you insure against a specific financial loss – the cost of a demolished automobile or a burned-out building.  Although no amount of money can compensate for the loss of a human being, there’s no definite monetary value associated with a person’s death.  So one must determine how much insurance is needed so that others are adequately provided for if you should die.

Life insurance is also different in that one of the basic principles of insurance – the principle of indemnity – does not apply to it.  The principle of indemnity limits the amount of insurance benefits one can obtain to the actual cost of dealing with the insured event.  If you own a house that would cost $350,000 to replace, you can’t collect more than that for its loss, even if you’ve insured it for a million dollars.  However, in principle, an individual can obtain an unlimited amount of insurance on his or her own life without showing that an “economic” loss would be caused by his death.

In practice, though, life insurance companies usually limit the amount of insurance that they’re willing to sell to 20 or 30 times the insured’s annual income.  Why?  Well, insurance companies worry that someone might purchase a large amount of life insurance with the intent of collecting on the policy fraudulently, either by faking a death or by causing one to take place.

The economic loss experienced when a person dies is usually described in terms of the individual’s future earnings potential.  If others are dependent on someone’s income, one purpose of life insurance would be to reduce the financial impact of the individual’s death on his or her survivors.  In addition to lost earnings, the financial impact of a death could include the cost of a funeral or the repayment of debts.

It’s common for insurance shoppers to employ “rules of thumb” in order to determine how much life insurance is needed.  I’ve seen figures ranging from eight to 15 times one’s income used in this approach.  Another method is to calculate the income you expect to receive between now and your retirement and then do a present value calculation to see how much life insurace would be needed to replicate your income.  This method is at least quantitative, but it ignores your social security benefits, the impact of taxes, and lots of other factors.  Some approaches are less useless than others, but none of the shortcut methods are good ways to determine the amount of life insurance one needs.

In order to accurately estimate the amount of life insurance needed, here are some of the factors that must be considered:

  • the future expected income of the insured
  • existing debts
  • expected future spending, including non-routine costs like college
  • future Social Security or pension benefits
  • likely costs associated with an individual’s death, including estate taxes and funeral expenses
  • lifestyle changes that might be made by the survivors in the event of the death of the insured

Another factor, beyond the scope of this post, is that an accurate determination of one’s life insurance needs requires understanding whether your household is living within its means.  If it isn’t, the insured’s current income may not be a sufficient guide as to the amount of money needed in the future by his survivors.  More importantly, if a household isn’t living within its means, this can’t be sustained indefinitely; it needs to be addressed.

Given a reasonable set of assumptions for these factors, one can ask: how much life insurance do I need?

To illustrate how widely the answer to this question can vary, consider some different scenarios.  You’ll have to trust me on the insurance calculations, as I’ll only have time and room to show the results, not the calculations.  This is a complicated calculation, so I use a cash-flow oriented software package called Naviplan that allows me to model a household’s income, expenditures, and other financial elements.  Once the model is in place, the software can simulate the death of a spouse and calculate what the financial impact would be on the rest of the household.  The model includes the effects of Social Security benefits, taxes, inflation, special expenses like college, and the presence of any liquid assets that could be used to pay for future expenses.  The software calculates the present value of any projected cash shortfalls in order to determine the amount of insurance needed.

Scenario A – Childless couple, one wage earner

Venn and Tess Tura are both 40.  Venn makes $50,000 a year as a state employee in Terre Haute, Indiana; Tessie is a homemaker.  They live well within their means and have modest tastes.  Venn has been saving 10% of his income in a 457 plan for some time and will be entitled to a small pension.  Making some reasonable assumptions about inflation and a reasonable rate of return for his retirement assets, it appears that they are on track for a successful retirement.  How much life insurance do they need?

In this case, today Venn needs $550,000 in life insurance, but his insurance needs will decline over time as their assets grow.  By age 50, he’ll only need $400,000 in coverage, and by age 60 his insurance need will disappear.  Since Tess’s death does not result in a loss of income, Venn would pay her funeral expenses but would not need insurance to bear the economic loss.

Scenario B – One Child, one wage earner, no college

Let’s suppose that the Turas have a twelve-year old daughter, Cholera.  Their spending is somewhat higher as a result, but happily Cholera wants to be a starving artist and has no plans to attend college.  For simplicity we’ll assume that Tess’ death would not result in child care or other costs, although if we wanted to we could build that into the assumptions.

Curiously, Venn’s current insurance needs will go down, to $520,000, even though their spending is higher.  Why?  Because if Venn dies today, Tessie and Cholera will receive extra income in the form of Social Security death benefits.  The calculation also indicates that if he dies at age 50, he’ll need $530, 000 in coverage because by then Cholera will be too old to trigger Social Security survivor benefits; Tess will still need income until she reaches an age at which she can file for retirement benefits.  At 60, since their spending is still somewhat higher than in the previous case, Venn will need $210,000 in coverage.  By age 63 their accumulated assets and Tessie’s future Social Security retirement benefits will be enough to provide for the rest of her life.

Scenario C – One Child, two wage earners, college

Things have changed quite a bit here.  Now Cholera is very musically gifted and hopes to attend a conservatory, so Tess has a job as a schoolteacher and is earning $50,000 a year.  Consequently, their lifestyle level is higher.  Like Venn, Tessie saves for retirement and is entitled to a modest pension.  The Turas are putting money aside in a 529 plan but will still have to pay for some of Cholera’s higher education out-of-pocket.

Will Venn’s need for insurance increase?  On the one hand, Tessie has an income now that would continue for her if he died, but there’s also a need to pay for college and their overall spending is higher.  As it turns out, Venn only needs $110,000 in coverage and Tessie needs $100,000.  By the time they are both 50, Cholera is out of school, and neither one needs any insurance.

In this case, an important factor is that even with the increased spending in this scenario, the Turas are still spending well within their means.  If their discretionary spending were to go up by just 10%, their present need for insurance coverage would almost double.

Let’s consider one last scenario.

Scenario D – One Child, Two wage earners with very different incomes, College

Now Tess is a very successful executive with an insurance company; she makes $200,000 a year and has much nicer retirement benefits.  They live in a much bigger home and have a higher lifestyle than in any of the other scenarios,

As you might expect, Tessie needs a lot more life insurance – $1.1 million today, dropping gradually to $810,000 at age 45, $310,000 at age 50, and going to zero by age 53 (this calculation doesn’t include money to pay the possible estate taxes that her heirs would have to pay at her death, so the amount needed could be larger, depending on how they configure their estate planning).  The coverage needed for Tess is now very sensitive to their spending habits; a 25% increase in spending would require another $1.1 million coverage for her.

Venn, with his now-measly salary, needs no insurance at all now.  Because of the large difference between the spouses’ incomes, the family would barely miss his income if it stopped, and there would be Social Security survivors’ benefits.

Accurate numbers versus “rules of thumb”
So – with four scenarios the calculated life insurance needs ranged from about 2 times to 11 times the salaries of the spouses.  If we’d gone with the lower end of the “rule of thumb” range (8x) across the board, the Turas might have bought a lot of insurance they didn’t need, or in some scenarios they would have been fairly under-insured.  Also, the amount of insurance needed varied quite a lot over the years, so the rule of thumb really would have been pretty useless except for the moments when it was accidentally correct.  These examples illustrate the weakness of “shortcut” life insurance calculations; they also show that changes in household circumstances can affect the amount of insurance needed in counter-intuitive ways.

For all these reasons, I’d argue that the only way to determine insurance needs accurately is to carry out the calculation properly, either by hand or with suitable software.  That, unfortunately, is not easy to do, but Insure.com has a nice article describing proper calculation of one’s life insurance needs.  The life insurance calculators I’ve found on-line are rather simplistic; the best one I can find is at fincalc.com, but it’s still probably too simple for many situations.  There is a financial planning software package called ESPlanner that can do this calculation , but the last version I saw was not simple to use.  Buying it might be overkill if all you want to do is figure out how much insurance you need.

One needs to do this calculation correctly.  It can be done by hand if you’re mathematically inclined and have the time.  For most people, I think the answer is either to buy ESPlanner and take the time learn to use it properly, or else obtain help from a professional.  Otherwise, you could close your eyes, use a “rule of thumb,” and hope you’re close…

Part 1 of this series, “Why Do I Need Life Insurance?,” is found here.

Part 2 of this series,”How Does Life Insurance Work?,” is found here.

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Thomas Fisher, CFP®

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