Related topics: insurance, life insurance, insurance rates, marriage, children
Unpredictable investment and job markets are rough on savings and retirement planning. They also complicate the issue of how much life insurance is right for you and your family and what kind you should buy.
Standard formulas -- such as buying coverage equal to eight to 10 times your annual income -- are inadequate shortcuts. Online calculators are apt to tell you to raise your coverage by $1 million even if you already have insurance. The truth is that life insurance is a personal affair. Two couples may earn equal salaries, but it's silly to say that someone with four young children should have the same coverage as empty-nesters with no mortgage and a substantial retirement fund.
Low inflation and a recovering stock market may tempt you to lowball your life insurance needs. But other financial realities, such as puny yields on reinvested lump-sum benefits, may require that you have more coverage, not less. And you'll likely experience life events that call for changes in your insurance: marriage, parenthood, homeownership, college expenses and retirement. Instead of relying on rules of thumb, you're better off taking a systematic approach to figuring your life insurance needs.
That's easier than it sounds, as you'll see from the following process, because it "truly is an art as well as a science," says Tim Maurer, a financial planner in Hunt Valley, Md., and a co-author of "The Financial Crossroads."
A simple strategy
The purpose of life insurance is to allow your family members to pay the bills and live their lives as planned despite your absence. That's why some experts and most online calculators sponsored by the insurance industry seek to figure the chunk of investment capital it would take to replace all of your income for 20 years or longer, held securely in Treasury or municipal bonds and certificates of deposit. With savings yields low and the prospect of longer life expectancies in retirement, this approach tends to aim high, especially if you assume raises and promotions.
"You can find people who are extremely minimalist with insurance recommendations," says Maurer. "But I see an overabundance of people who end up justifying more insurance than I think is reasonable."
Instead, he offers a simple strategy to calculate how much coverage to buy and to form a plan that's easy to update. The idea is to assess whether you need extra coverage or different policies only after you project your life insurance needs as the sum of four categories.
- Final expenses. A funeral, burial and related expenses tend to cost $10,000 to $20,000. Your beneficiaries may be able to get the tax-free proceeds from insurance faster than if they waited for money from your estate. Use $15,000 as a ballpark number.
- Mortgages and other debts. Total your mortgage balance, car loans, student loans and any other debts that would be a heavy burden on your survivors. They may choose not to retire the mortgage, especially if the interest rate is low, but the money should be available so that they won't face the prospect of being forced to sell.
- Education expenses. This calculation can be tricky, because you need to consider the cost of college at the time your kids enroll. But Maurer devised a simple solution. College costs have been rising by about 5% a year, which is the same rate he conservatively expects life insurance proceeds to grow over time. He recommends looking up current costs for colleges you're considering, deciding whether you want the insurance to cover all or a portion of the tab, and adding the amount in today's dollars to your life insurance calculation.
- Income replacement. Once you cover funeral expenses, debts and education, your family won't need to replace 100% of your income -- and that's where the art part of the calculation comes in. Maurer recommends covering 50% of current pretax earnings until retirement. You can translate this into a target lump-sum benefit by dividing it by 0.05. For example, if you earn $100,000, divide $50,000 by 0.05, which works out to $1 million. That assumes the insurance benefits will earn 5% a year over the long haul, a conservative back-of-the-envelope figure.
Add all four categories to estimate how much life insurance is appropriate, then tweak the number to reflect personal circumstances. You might increase it if you don't have a pension, but you could decrease your coverage if your spouse earns a substantial salary. If you or a family member has a troublesome medical history, add $100,000 or even $250,000. If you're the one with the medical condition, you'll find it tough to buy additional coverage later at a price you can afford.
