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How Much Life Insurance Do I Need?

MONEY TALKS - I am frequently asked by clients, friends, and family members; how much life insurance do I need? More often than not, before I have a chance to respond, they begin telling me the balance on their mortgage, why they have so many credit cards, and the number of years remaining on their student loans. Unfortunately, while this information may be useful when creating their financial plan, it’s not relevant when determining their life insurance needs.

Debt Replacement - Most people tend to take a Debt Replacement approach when evaluating how much life insurance to buy. They simply add up all of their major debt and buy an equal amount of life insurance. For example, if your mortgage was $320,000; student loans were $35,000; and auto loans were $20,000 then you would buy $375,000 in life insurance. Since the household debt is the same for both spouses, your spouse would get a policy for the same amount. The problem with this method, while logical and easy to calculate, is it has some major shortfalls. Most notably, the Debt Replacement Method completely ignores how much income is earned and whether or not the surviving spouse can maintain their current lifestyle even if they are debt free.   

Consider this scenario: Jim, a 45 year old father of three makes $150,000 a year as a software engineer. While watching the Patriots game, Tom Brady throws an ill-timed interception in the red zone. Jim clutches his chest, falls to the floor and suddenly passes away from a massive heart attack. His wife, Anna, is a stay at home mom with no earnings outside of the interest on her savings account. Jim and Anna’s household debt totaled $375,000 which also happens to be the amount of insurance each spouse has in force. Six weeks after Jim’s funeral Anna gets a check in the mail for the life insurance proceeds and immediately pays off all of their debt. An immediate sense of relief passes through her body knowing she will never have to make a mortgage payment again. Regrettably, in a fleeting moment her sense of serenity is gone and replaced by a strong feeling of anxiety.

The problem is, although Anna no longer has a mortgage payment, student loans, car payments, or consumer debt there are still other expenses she will incur to support her family needs. Real estate taxes, utilities, gas, and groceries are just a few expenses that would not be covered by the insurance proceeds. Without an income stream to support her family, Anna would be forced to sell the house just to make ends meet. Although the Debt Replacement Method makes sense logically, it is not practical when actually applied to a real life scenario.

Income Replacement – Working Spouse - The Income Replacement Method is a much more comprehensive and suitable way to determine your coverage needs. This method works well because it essentially replaces the income stream of the deceased spouse. However, it should be noted that calculating your coverage needs can be more complex using this method and should be done by a professional. The amount of coverage needed is determined by calculating a present value of your after-tax income stream from now until your projected retirement date. The reason after tax income is used rather than gross income is because life insurance proceeds are tax free. Projected retirement date is important because it generally coincides with the end of your income stream. In other words, you only want to replace the income stream until your working career ends. Expenses such as mortgages, consumer debt, and college tuition are not factored in because these expenses are usually paid out of your income. Since your earnings are being replaced, expenses can be ignored to avoid double counting your insurance needs.

Going back to our example, if we rerun our calculation based on the Jim’s age (45), projected retirement age (65), after-tax income ($105,000), and projected post-inflation return on investment (5%), the income replacement method tells us Jim would need a lump sum of 1.3 million to replace his income stream for the next 20 years. In this scenario Anna could remain in her home with the kids without having to worry about going back to work or selling the house because the household income would remain the same.

Income Replacement – Stay-At-Home Spouse - While the Income Replacement Method works well in most scenarios, it’s not without its faults. One problem with this method is, if we reverse the circumstances and assume Anna predeceases Jim, the Income Replacement Method tells us Anna doesn’t need any life insurance because there is no income to replace. In cases where one spouse doesn’t work or works part time, we need to take into account what services they provide to the household that allow the primary wage earner to continue working. Services such as cleaning, cooking, and watching the kids would have to be replaced by hiring a cook, maid, and au-pair. The cost to hire these professionals should be used when factoring how much “income” should be replaced. Don’t be surprised if the stay at home spouse needs the same or more insurance than the working spouse. According to Salary.com the value of a stay at home mom is almost $119,000 nationally!

What Does the Future Hold? - Evaluating your life insurance needs can be a tricky exercise because no one knows what the future holds. Estimating your future earning potential, retirement date, and return on investment can be a daunting task. Changing just one factor slightly can have a major effect on the results. When evaluating your needs be sure to consult with an experienced and unbiased professional before determining, “How Much Life Insurance Do I Need?”