It’s a common question: How much life insurance should I have?
The answer; unfortunately, isn’t an exact science. However, I’d venture to say nine out of ten potential clients are underinsured. Whatever the reason (lack of time, not working with a professional to diagnose need, or refusing to deal with our own mortality), it doesn’t change the potential, catastrophic impact being underinsured may have on your family.
Many of us have received that horrific email, or seen a Facebook post, about a benefit for some widow and her 3 children at the local church or fire hall. The intention is great and shows the best qualities of people. But, it is inevitably a futile exercise. At best, these events raise $5,000-$10,000 for the family in need. In reality, that only covers (maybe) 2-3 months of expenses. It’s heartbreaking to see this happen to great people. I don’t want to see it happen to you. Thus, the impetus of this post is to help educate on the appropriate amount of insurance.
Before we figure out how much is appropriate, I’d like to start by explaining why we purchase life insurance in the first place. At its core, the purpose of life insurance is to fund that financial gap between if one was to remain alive vs. passing away. That gap is created by lost wages and any special one off items above and beyond (i.e. special vacation, memorial fund, and college tuition). Many people undervalue the dollar worth of their lives and the financial impact they have on their family. There is an old life insurance adage that I think speaks volumes: If you had a machine in your basement which kicked out $100,000 a year for the next 10, 20, or 30 years, how much would you want to insure that device? Makes sense, right?
The Methodology of Need
Financial Planners typically use two main methods for determining life insurance needs: Human Life Value & Needs Based Approach.
- Human Life Value: Is the way to ascertain the value of one’s life by attempting to quantify the future earnings potential, expenses, and years remaining in the work force. What this method doesn’t take into consideration is inflation, career, wage growth, or spending drift.
- Needs Based Approach: This approach is probably more utilized today (over the Human Life Value method). The Needs Based Approach determines the amount the surviving family needs to continue living the same lifestyle they’ve be accustomed to. This approach factors in future incomes and assets (such as 401(k)’s and pensions). It also takes into consideration future wants (like paying for college or weddings for your children) that the Human Life Value misses. In addition, it typically puts more value on a non-working spouse as well. Their value typically isn’t quantified by income brought to the table, but rather expenses saved by them working as a homemaker.
Three Major Considerations
There are really three major decisions to be made during this process.
- How long do I need (or want) to have this coverage? As most of the time the exposure is for a finite period?
- How much do I need?
- What is the right type of coverage? (See my previous blog post perm vs. term.)
Other Things to Remember
- Life insurance proceeds are income tax free.
- Determine a figure (of need) and then add to it or round up. Trust me on this one.
- Shop around with carriers. Ratings and costs will matter, as different insurers will look at you differently.
- Be sure your beneficiaries are structured correctly. This may involve using trust planning (a great idea if the beneficiary is a child).
On a personal note, this is very close to my heart. Early in my career I sold a $1,000,000 life insurance policy to a young couple whose first child was on the way. Less than a year later, I got a call that the wife passed away in a motorcycle accident. Sitting across from the husband and handing over that life insurance check, I knew I had done right by him. It would not bring his wife back, but I know it has forever changed his family’s life path. I wish more people would avoid this dangerous financial planning trap and provide one less thing to worry about in the midst of a tragedy.