Many people I work with realize that they need some kind of life insurance once they start having kids. The purpose of life insurance, of course, is to ensure that everyone in your household can maintain their standard of living if you die prematurely. And as soon as other people start relying on income you haven’t earned yet to live, it’s probably time to consider some coverage.
The problem seems straight forward, but the options are confusing. First, there’s more than one type of life insurance. Whole, variable, universal, and term are the predominant options available. While insurance agents love to sell the first three (because they’re the most profitable to the insurance company, and therefore pay the greatest commissions) term is the least expensive and usually the best fit.
I’ve written in the past about why most people seeking life insurance should steer clear of permanent insurance policies. But what about the second part of the equation: how much do you really need?
There are two predominant ways to figure this out: human life value and a life insurance needs analysis. Today’s post will explore both methods.
Human Life Value
In a human life value analysis, the idea is to quantify the financial impact of premature death. If you died unexpectedly, your family would be without the benefit of your future earnings. Human life value determines how much insurance you’d need to replace the lost future income.
There are a couple variables here. To start, take your annual income and try to estimate future raises and other increases. Then, adjust for taxes. 30% is a pretty safe assumption for most people. Since the death benefit from life insurance will be tax free to your beneficiaries, you’ll want to make an apples to apples comparison and determine the after tax income they’d be missing out on.
You’ll need to assume a discount rate. This is the same as the return on investment your beneficiaries should expect from a death benefit. Whereas we usually like to assume rates of return between 6-8% in financial planning and retirement calculations, you’ll want to be more conservative here. If you wind up needing to use the death benefit of a life insurance policy to pay living expenses, you’ll probably want to take less portfolio risk. 4-5% is a better assumption for this purpose, as it’d allow you to invest the proceeds in a diversified bond portfolio with little (if any) equity risk.
Finally, you’ll use the discount rate to determine the present value of the future income your family would be missing out on. For example, if you make $100,000 per year and died tomorrow, your family would missing out on a substantial amount of cash. If you used 4% discount rate and a 30% all in tax rate, that $100,000 would be worth $67,307.69 today: ($100,000 * (1 – 30%)) / (1 + 4%).
The human life value analysis is the same present value calculation for ALL your future earnings. Using the example above, you’d simply add year 1’s lost income to year 2, year 3, and so on. A good financial calculator will help here, but there are also plenty of good calculators available online. Lifehappens.org has one, as does Nerdwallet.
Rather than calculate the total value of your future income your family would be missing out on, a needs analysis simply adds up the amount your family would need to maintain their standard of living. In other words, total up all your family’s future liabilities should you die prematurely.
Typically this starts with your own final expenses, including a funeral, cremation, burial plot, and/or settlement of your estate. Then, add up the annual income your family would need if you died today, and how many years they’d need it for. If you have a retirement plan in place, this is probably the same number of years until you plan to continue working for. Make sure to budget for retirement, education and other savings too, if necessary.
You’ll then need to account for your spouse’s after tax income, if they would continue to work upon your death. This will be subtracted from the calculation. If they’d stay home to raise the kids, do not include their income.
Finally, you’ll need to make two important assumptions. The first is what you expect inflation to be. Long term, inflation on most goods and services we use is about 2.5%. Some financial planners I know prefer to err on the side of caution and round up to 3%. Either is appropriate. Then, just as in the human life value analysis, you’ll need to apply a discount rate. And just as in the human life value analysis, you’ll want to be conservative. 4-5% is right in the ballpark.
From here the calculation is similar to the human life value analysis. But rather than determining the present value of your future earnings, we’re determining the present value of your future needs. Spreadsheets and/or financial calculators are helpful here. But again, there are a ton of handy calculators around the internet. Here’s one from Bankrate.com, and another from Lifehappens.org.
Should You Include Your Debt?
Some people will want to add their total amount of their debt to the calculation. This enables your beneficiaries to use part of the death benefit to pay off your mortgage, auto, and other loans. The benefit here is that your beneficiaries don’t need to rely on investment growth to eventually become debt free. Rather than investing the death benefit and paying off debt little by little by budgeting them into their living expenses, you’d be clearing the debts from day one.
Many people prefer to pay down debts as slowly as possible – especially since interest rates are so low. That’s not the best course for everyone though, and if your beneficiaries are uncomfortable with risk you may want to use a death benefit to pay everything off. Since your family would be dealing with a lot emotionally should you die prematurely, ridding them of debt is one less thing to worry about.
Just know that when your expected investment returns exceed the interest rate you’re paying on your debt, adding debts to the death benefit will increase the total amount of insurance required. This is likely in today’s environment, even if you’re only expecting 4-5% in returns from the death benefit.
What Human Life Value & Needs Analyses Mean For You
Typically I like to run both of these analyses for my clients. They attack the same problem from a slightly different angle, which provides some context for decision making.
Usually human life value will come up with a higher number than a needs analysis. If the needs analysis is higher, it most likely means you plan to spend more than you earn – which is probably not a good plan. Most people I’ve worked with prefer to land somewhere in between the death benefits provided from a human life value & needs analysis. That way there’s enough money for everyone else in the family to continue their standard of living, but a little extra available to help deal with the emotional trauma.
In the end, the right path for you depends on what it is you’re trying to accomplish. Term life insurance may not even be the best option given your specific circumstances. But for anyone who’s trying to protect their future income from premature death, who expects to become financially independent, term life insurance will be the best & least expensive vehicle.