A common question we help our clients answer is how much life insurance they really need. It’s not an easy question to answer, because there are a lot of things you need to consider. Is the employer-provided insurance that is part of your benefits package enough? Is the policy your mom got you when you were a kid enough? Does the amount change when you have a baby? What about paying off your loans? What about paying for final expenses?
For purposes of this discussion, I’m going to focus on only term insurance. Permanent insurance like whole life, universal life, or other policies that have a savings component to them are more complex and more expensive. I’m also not going to get in to how long you might need your policies to be, i.e. a 20-year term policy, a 10-year term policy, etc. I’ll just focus on how much death benefit you might need.
There are a few different methods for calculating how much insurance you need, so I’ll describe each one, and list some of our thoughts on the different methods.
A quick and easy method to calculating how much insurance you might need is an income multiplier. For example, you might hear that you should buy 5x, 10x, or 20x your annual salary. The benefit of using this method is that it’s easy to calculate. Logically, it kind of makes sense, too. Life insurance is oftentimes viewed as an income replacement insurance product, so a policy that is 10x your salary would replace your income for 10 years — maybe more, because a lot of your current salary might go to pay income taxes, but the death benefit on a term insurance policy isn’t taxable. So, you might figure that your spouse or significant other could get by for the next 10 years with that much life insurance on your own life. Pretty easy!
The downside to this method is that it doesn’t consider how much you spend, outside sources of income, outside assets, or any goals. Some people want life insurance to pay off their mortgage or student loans, and this method doesn’t directly consider those numbers. Or perhaps a couple wants a policy to fully fund college savings for their kids. Again, an income multiplier doesn’t directly account for that.
Ignoring spending can also be erroneous. What if you make $200,000 per year, but your spouse also makes $200,000 per year, and your family spends a total of $100,000 per year? Wouldn’t your spouse’s income pay for your family’s expenses if you passed away? Or what if you are a stay-at-home mom and you don’t receive a paycheck, but you take care of four children, and your husband would have to pay for childcare if you passed away? Ignoring expenses and only focusing on income has its flaws.
Human Life Value
The human life value is another method of calculating life insurance need. I hate the term, because it literally places a number — a value — on a human life. The calculation method does what the name implies. Basically, you calculate how much money you’re going to make for the rest of your life, subtract how much you’re going to spend for the rest of your life, perform a time value of money calculation (i.e., put everything in 2019 dollars), and you come up with the “value” of your own life. Then buy a policy for that amount.
Interestingly, if you correctly project your future earnings and expenditures, the value that you calculate under this method decreases over time, because as time passes, the remaining amount that you will earn throughout your life decreases. Some policies exist that support this methodology. You can actually buy policies that have a decreasing death benefit as time passes, perceivably because your human life value declines over time.
The benefits of this policy is that, compared to the income multiplier, you actually consider how much you spend. You’re not buying insurance to replace the money that paid for the food you ate, because you won’t be around to eat that food when you pass away. But like the income multiplier method, this method also ignores outside sources of income, other assets, and goals.
The third and final calculation method that I’ll mention is the needs-based method. The term here is pretty accurate — you buy the amount that you actually NEED, instead of buying an amount based on your salary.
So how much do you actually need? This depends on your goals. If you set financial goals, it becomes less difficult to calculate how much you need. Not easy, but less difficult. Basically, you’d need to set goals for the scenario in which you pass away, consider all sources of money to help pay for those goals, and calculate whether there is a shortfall. For example, a couple might determine that if one of them passes away, they want to be able to spend $50,000 per year, and they don’t want their surviving spouse to have to remarry to accomplish that. If the surviving spouse only makes $40,000, they probably need some insurance. But maybe not! What if they just inherited some money from a parent who passed away, and those proceeds could replace the income of the surviving spouse? The other life insurance methods ignore that pot of money.
Another easy example is the case where the spouse who passes away had earned a pension that will be paid to the surviving spouse. In that scenario, the pension — plus the income of the surviving spouse — might provide enough income to pay for the surviving spouse’s expenses.
There are a lot of other factors to consider, and even when they are considered, no one can predict the future. You don’t know exactly how much money you’ll need 20 years from now if your spouse passed away today. But we can use all information that is currently available to us to make our best attempt at calculating an appropriate amount. That’s possible through holistic financial planning. As fee-only financial planners, we help our clients think through these factors, and we offer advice for specific scenarios. Plus, we’re not insurance agents, so we don’t make money on selling insurance. We don’t benefit from recommending you purchase more than you need, so we’re one of the few ways you can get unbiased insurance advice from someone who has education and experience with insurance.
If you don’t have a fee-only financial planner and you want to do it on your own, there are a few other ways that you can calculate your need. But be sure to talk to an insurance agent you trust who won’t oversell you and who genuinely cares about you.