In previous posts, we discussed permanent vs term life insurance, as well as the various types of permanent life insurance.
While it’s extremely important to determine which type of life insurance policy is right for you, how do you know if you’re properly covered? How much life insurance do you really need?
This week, we’ll cover two basic approaches used to determine the proper amount of life insurance coverage – the human value life approach and the needs approach.
Human Life Value Approach
This approach attempts to calculate the net value of a person’s future earnings potential (i.e. how much are you expected to earn in net income through the remainder of your life).
1. Project your average annual income through the remainder of your expected working years. This projection should take into account future salary increases. For example, say you are currently 40 years old, earn $70,000 per year today, and plan to retire at 65 when you expect to be earning $150,000 per year. By taking the average of your current and ending salary you can get a simple average earnings value of $110,000 ([$70,000+$150,000]/2).
2. Determine your net contribution by taking out taxes, insurance deductions, and any other living expenses related specifically to just you. Let’s assume your average taxes/expenses come out to 70% of your income. This makes your net contribution $33,000 ($110,000 x 30%).
3. Determine the number of income earning years remaining before retirement. In this case we assume you have 25 years left to work (65 – 40).
4. Take the net contribution value from step 2 and multiply it by the number of years remaining before retirement in step 3. This gives you a total life insurance need of $825,000 ($33,000 x 25).
This is an easy way to estimate life insurance needs, but there are some drawbacks as it is very simplified. Most notably, this method does not account for inflation or changes in living expenses. You would also want to consider other factors such as growth of your assets as well.
For these reasons, the needs approach is becoming more popular to use.
Needs Approach
This is a widely used alternative to the human life value approach. The needs approach attempts to calculate how much life insurance is required for a family to cover their expenses. This approach is generally preferred as it considers actual expected expenses of a family rather than just replacing expected income.
1. Determine Immediate Needs at Death (cash required to cover some one time expenses). These costs include final medical treatment expenses, funeral expenses, estate settlement expenses, readjustment period funds, and other one-time obligations. Depending on your preference, you can also include costs such as mortgages and college savings as a lump-sum rather than as ongoing payments.
2. Determine Future Ongoing Family Needs (continuing income required to meet family expenses for the remaining life of the surviving spouse). These costs include child dependency expenses, college costs, debt repayments, surviving spouse retirement income, and other ongoing obligations. To find the total value of these needs, simply determine your expenses and multiply them by the number of years the expenses will continue (ex: if mortgage payments are $2,000 per month for 10 more years, the mortgage need is $240,000 total). Add up all individual needs to develop your total.
3. Once you add up the total needs determined from 1 and 2, you need to account for currently available assets and income by subtracting these values from your needs. Available assets can include bank accounts, real estate, retirement funds such as 401(k)’s, and other available assets that can be liquidated if needed. Income includes Social Security survivor benefits, surviving spouse wages, employee pension plans, annuity income and other types of available income.
Let’s use a simplified example for the needs approach. Say your immediate needs consist of $10,000 funeral expenses, $50,000 in readjustment funds, and $200,000 to pay off the mortgage in full. Future ongoing needs will be $300,000 total for child care and $900,000 total for the surviving spouses’ retirement. This gives us a total expense need of $1,460,000, but now we must factor in assets and income. Assume you have $50,000 in savings, $500,000 in a 401(k), and $400,000 of expected future Social Security income for a total of $950,000 in available assets/income. This gives us a total life insurance need of $510,000 ($1,460,000 – $950,000).
Determining your total life insurance need can be a demanding process, but taking the time to do this can be extremely beneficial.
Many people are under-insured because they do not take the time to understand how much coverage they’ll actually need. This can leave your family in a bind if you happen to pass away unexpectedly.
Others are over-insured and pay too much in premiums because they purchased a large policy “just to be safe”. This can cause an unnecessary strain on your current income and cash flows.
Life insurance needs change throughout your life, which makes it very important to periodically review your actual needs and plan accordingly.
Ben and Derek
Co-Founders and Owners of Aspire Wealth
*Please note, this is not intended to be advice. We are not insurance experts and you should work with your financial planner prior to implementing any strategies we’ve discussed.
Permanent Life Insurance
