There are two ways to calculate life insurance needs. The first, generic, and most common method is to base an insurance need on a multiple of salary. This is formulated as needing, for example, 10 times, 17 times, or even 20 times your current income. This approach is fine as far as generic advice goes—I recognize that there needs to be some sort of simple formulation—but it also fails to take many things into account.
The second method, and what I typically conduct with my clients, is a needs-based analysis of life insurance. What are the actual costs which would be left behind at death? What debts do you have? If applicable, are you and your spouse done having children? Will your spouse be able to continue working if you were to pass? If not, what will the monthly shortfall be?
When done to the fullest extent, the entire formulation includes cash flow budgeting, inflation, a growth rate on money, and other variables that can’t be accounted for in one article. However, today I wanted to impart a framework for the basic phases of life that most households go through and how your insurance need can change over time.
When trying to visualize how much life insurance a person should carry, I get the mental image of an arch in the shape of a circus tent. As you move through life there is an ascension, a brief peak, and then a slope which declines as you prepare for retirement. While numerous factors play into it, the need for life insurance can be roughly defined by phase of life.
YOUNG AND SINGLE
For the generic young, single person completing college and/or moving into the work force the need for life insurance, if any, is quite minimal. After all, in the broadest view, the real purpose of life insurance is to protect and provide for a spouse and family after your death.
Aside from marriage, the need for life insurance first appears once a young person takes on debt. Note that this does not include federal student loans, which are generally forgiven at death. I typically encourage young people to have enough insurance to pay off all debts after their death, which means that the initial need for life insurance typically appears with someone’s first mortgage. An insurance policy may not be strictly required if they have enough offsetting assets to leave behind a positive net worth at death. However, even for a twentysomething a life insurance policy can provide a positive feeling in knowing that, if something happened to you, you would leave behind something other than debt.
MARRIED, WITHOUT CHILDREN
The equation can change once our fictitious young person marries. At that point, the baseline need for coverage remains the same. However, now enough coverage is required to pay off the debts of both spouses. For example, when calculating my life insurance, I might include enough so that my wife, at my death, could pay off the mortgage and her student loans. Because each person should carry enough coverage to eliminate a combined debt load, conceptually you may say that the need for insurance doubles.
Beyond debt elimination, consideration should be given to your spouse’s retirement and other financial goals. In the broad category “a married couple without children”, any additional needs can vary wildly by age.
For example, a couple in their fifties will typically feel much more strongly about ensuring (and insuring) that a surviving spouse could comfortably move toward retirement after the first death. If they are under-saved for retirement, it would be appropriate to make this up through life insurance (instead of making saving for retirement even more difficult after the death).
This is usually less of an emphasis for a young couple where, assuming a premature death, the survivor would be more likely to remarry and still have a long-time horizon to fund their own retirement. I find that couples at the younger end of this consideration gravitate toward a middle ground of providing some additional funding (beyond debt elimination) to allow the surviving spouse to take time off, go back to school, or otherwise partially subsidize retirement. However, the purpose of life insurance for a twentysomething generally isn’t to pay for the full lifetime retirement of their survivor.
MARRIED… WITH CHILDREN
The most significant change in determining appropriate life insurance coverage comes as households have children. Naturally, the more children you have, the more insurance you should have. Conceptually, for most people, their peak insurance need comes the day their last child is born.
In having children, the primary infusion of need for life insurance purposes is to pre-fund college (and, if applicable, funds for private high school or other education desires). The appropriateness of funding college through life insurance is frequently even applicable for household’s that say they aren’t going to pre-save or pay for college otherwise. Very few people want to leave behind a world where they pass away and the surviving spouse can’t afford the best for the kids.
(NOTE: Considerations are similar for someone who is not married but has children: life insurance to pay off any debts and send kids to college. Additional factors should be discussed with a co-parent).
Naturally, at this phase in life you can be looking at some pretty significant life insurance amounts. It would not be out of line for a household with three kids and a $300,000 mortgage to have life insurance in the high six figures or low seven figures.
For households with young children, it also becomes more common to desire to provide a salary replacement through life insurance to allow the surviving spouse to take time off work while the kids are at home. This can be expressed in manners such as, “enough life insurance to allow my wife to take two years off work while the kids are young, and then only have to return part-time”. While, obviously, this can lead to some complex calculations, most people could do “back of the envelope” math to come up with a good approximation.
THE DECLINING NEED
The need for life insurance typically peaks while kids are young and then begins to decline over time. This is true as a family slowly moves closer to retirement. Where debts are paid down over time, savings is accumulated, and kids get older, a family conceptually needs less life insurance each year. By the time a family reaches retirement any remaining life insurance need is very minimal. I often express to clients, half-jokingly, that if you can afford to retire you can afford to die. In reality, there are good reasons why older people may choose to continue carrying some life insurance, but these motivations fall more under the “luxury” category—leaving an inheritance—than under the utilitarian necessity of providing for a family.
If a life insurance need is often greatest at what we can call the “mid-phase” of your working years—married with children and beginning to accumulate assets and pay down debt—what is the best solution for coverage? In practice, I often encourage young people, single or married, to purchase more life insurance than they need at the time. The reasons are severalfold.
First, it helps to avoid the disastrous scenario of finding out after you NEED the coverage that you are uninsurable. It is better to buy coverage while you are young and healthy as opposed to delaying and assuming that your good health will last forever.
In addition, term insurance is incredibly cheap for young people. In fact, for people in relatively good health, individual term insurance through a private company is usually cheaper than coverage offered through an employer. This is true because—at least for amounts that don’t require a medical exam—everyone in employer coverage is lumped into a sort of generic, “standard” rate class; even the young and healthy.
Persons who are young and healthy are best off purchasing an excess of term insurance for a time period of twenty or thirty years, and having that premium locked in. With hindsight, 40% of people who purchased insurance later wished they had purchased more insurance at a younger age.
At Liberty Tree Asset Management, I work as a broker of term insurance and can help clients shop rates from dozens of top-rated companies. We can determine an insurance need through either a “multiple of salary” approach or a needs-based analysis and, after a few medical questions, can shop the coverage to determine the ideal company at which to apply. Please reach out for a consultation.