There are a bunch of different ways
to determine how much life insurance you need, from a simple “ten times your
salary” to complex Monte Carlo simulations. Somewhere in between is the
“capital needs analysis”, which is often used by insurance brokers and financial
planners. This is what most online life insurance calculators use (examples
here, here, and here), although I like the idea of doing it by hand to play
with the numbers. I have a brochure from my State Farm agent with some stats.
What is your goal?
Here’s the fun part. You get to
imagine you’re dead. Will the remaining partner stay at home with the kids?
Work and pay for daycare? Some people basically want to replace everything –
their future income and also leave an inheritance or other lump-sum. Others
want to make sure their dependents would be able to live as close to the “same
life” as possible. This means staying in the same house, working (or not
working) at the same jobs, driving the same cars, the same lifestyle. Then
there is the “adapted life” approach, where maybe they would downsize somewhat,
but have all the critical areas covered.
How much monthly income will your survivors need?
It’s usually easier to think of
this monthly, and then multiply by 12. Include housing, transportation, education,
childcare, insurance, entertainment, and perhaps also regular retirement
savings. The average cost of daycare for a 4-year-old is around $8,000 per
year. Now subtract any sources of income. The survivor’s salary, existing
passive or investment income, rental income, Social Security benefits, etc.
Then, you have to decide what
amount of money can create this income. Lots of guessing on your rate of return
and length of withdrawal period is involved here. If you are young, you could
buy an immediate annuity which will pay out about 4% inflation-adjusted a year
(a certain % will be taxable). This is the same as multiplying by 25. So to
create an annual income of $40,000 per year, you’d need a lump sum $1,000,000.
As you get older, the payoff gets better. A more conventional approach seems to
multiply by about 15.
Add in lump sum expenses
You’ll probably want to take care
of debts like student loans, credit cards, funeral costs, and medical bills. A
recent survey put the average funeral cost at over $6,000. If you haven’t
already accounted for it above in housing, you may want to pay off the mortgage
on your home or set aside money for retirement. Finally, you may want to
consider the education costs of your children. The average cost for tuition + room/board
for an in-state college is now nearly $14,000 per year.
Add these two big numbers up, and
you have you future capital needs. You can then subtract out the insurance you
have through work if you like. Finally, you should subtract your current assets,
taking into account their liquidation restrictions. The difference provides an
estimate of how much Life Insurance Calculator to shop for.
This all sounds simple, but in
going through it myself there are so many variables. For starters, most couples
will probably have different insurance needs for each person. Do I really want
to pay off the entire house, or just allot for the mortgage payment? How many
kids am I supposed to plan for? I end up with a number anywhere between
$500,000 to more than $1M depending on different assumptions. (I’m open to
advice here.) The good thing is that I am hoping that each $500k of coverage
will only be about $30/month. I also may end up buying multiple life insurance
policies as life goes on and stack them on top of each other.
Inflation?
If you buy a 30-year term policy
with $500,000 of coverage now, at 3% annual inflation that you benefit will
only be worth half as much after 23 years. But I don’t really worry about that,
because for every year that I keep living, I should be saving enough that I
don’t need as much coverage. And after the end of my term, we should have
enough assets so as to not need any life insurance at all.
