HOW MUCH INSURANCE IS NEEDED
How much life insurance should be purchased has been the topic of countless books, articles and computer software (don't always believe the computer!). Below is a basic table showing how it is done. You absolutely must do a budget in order for this to work properly since the whole process is keyed to how much you would spend in any given time period. You also need to "know" what you would get as a return if you had a lump sum of insurance to invest. It basically works this way- if you are a very conservative "investor" and are only using money market funds, you will need a LOT of insurance coverage since your earnings on the investments won't "go very far". If you are comfortable in earning 7%- 10% returns, the amount of insurance is less overall since you get more returns each year off the investments. It's the same focus that one takes when dealing with receipt of insurance funds after a loved one dies. If you know how to invest, the assets can last a long time. If not and you use the life insurance company options, you may not have enough money for a lifetime.
I have offered commentary at each of the various areas- and they are essentially the same commentary I offer to the agents when I do continuing education.
Compare this to any other method a salesman might use. The end numbers should
be close, if not- caveat emptor. Do this analysis for EACH spouse (you substitute
incomes and situations). The total of both is the amount needed. Also note
that the amount of insurance needed is based on the issue that the clients
died NOW.
1. Funeral, Administrative and Estate Tax Expenses.............................................. _______
Funeral costs can vary a lot and this link can help. Administrative costs for filing taxes, estate forms, probate and always present- even with living trusts. And estate taxes can start at 37%.
2. Debt resolution (includes mortgages)..................................................................._______
You don't have to plan for the debts to be paid off- particularly if the survivor is scheduled to still have a substantial income. But the "normal" thought is to pay off existing debts.
3. Emergency fund (varies from two to six months take home pay.)........................ _______
I have always taught that consumers should allocate for a six month emergency fund. However, it does not have to sit in cash or a money market fund earning next to nothing. Maybe four months of the value could be invested with other investment monies. You can always get to it with a simple telephone call.
4. College fund................................................................................................________ (remember this contingency is only funded upon your death- it's the living part of college expenses that is the problem). Anyway click here to see what the numbers actually may be.
5a. Net annual living expenses (first stage)
a. Average annual living expenses ......................................................................... _______
This is the critical area for anything to do with proper planning. As stated repeatedly elsewhere, a budget is a more critical item for future planning than is the net worth statement. If you don't know how much you are spending and where, you don't have any realistic idea of how long the money will last.
b. Spouse's annual income (in case of working spouse, be aware that income could be substantially different after first death since they may need more babysitters, can't work as much overtime, etc. ..........................................................................................._______
c. Social Security.............................................................................................. _______
Available to surviving spouse if there are children under the age of 16. Social security is also paid to child(ren) until they turn age 18 or 19 if still in high school. Pretty difficult to figure out the numbers yourself. You really should contact social security directly. Also note that social security is available to widows(ers) at age 60 is the spouse had been covered by social security. The period when no social security benefits are available is called the "blackout period".
d. Net annual income needs (a-b-c)......................................................................_______
e. Number of years for analysis............................................................................ _______
If there are no children, one might figure a budget till age 60 when social security is available and then one more budget/time frame until death.
f. Present value of an annuity due using an assumed real growth after inflation and taxes. Stay conservative and don't use 15% returns which are ludicrous. It should be something in line with the stock market historically IF you are an investor. If you are NOT an investor, use the returns on the accounts you currently have.............................................................. ______
For example, if you needed $25,000 for the next five years and were to invest it a 8.5% (after tax), the present value would be $98,516. If the return was only 4.5% , the present value would be $109,749. It essentially means you would need $11,233 MORE in insurance because of the lower returns during those five years. Do the calculations really work this way in real life. NO! What actually happens is that the budget actually INCREASES by the rate of inflation to the next year, etc., etc., and different calculations are necessary. If inflation was 3.5% and the return was 8.5%, the needed lump sum (insurance) would be $108,745. If the return was the 4.5%, the needed lump sum (insurance) is greater at $121,457. That's $12,712 more of insurance.
Now, I don't expect all of you to understand this. But your agent MUST. Further, one MUST have an idea of what is going on inside the computer program in order to properly decipher how much insurance you really need to buy.
5b. Net annual living expenses (second stage) ......................................................_______ This may be the period after the social security stops because the child is over 16 and the blackout period for the survivor begins until age 60. So a new budget for that time frame is necessary.
a. Average annual living expenses...................................................................... _______
b. Spouse's annual income (may be lower if the children have left home.)............_______
c. Social Security (none to survivor if children over 16) .......................................______
d. Net annual income needs (a-b-c) ................................................................._______
e. Number of years for analysis........................................................................ _______
f. Present value of an annuity due using an assumed real growth after inflation and taxes. Stay conservative.. ...................................................................................................... _______
5c. Net annual living expenses (third stage). This could be the period from 60 to age 85, for example
a. Average annual living expenses till death.......................................................... _______
b. Spouse's annual income (normally much lower during retirement...................... _______
c. Social Security (Could be survivor's amount or that from deceased's account)... _______
d. Net annual income needs (a-b-c)...................................................................... _______
e. Number of years for analysis............................................................................ _______
f. Present value of an annuity due using an assumed real growth after inflation and taxes. Stay conservative. ....................................................................................................... _______
(You may not need as many times frames- though you may need more depending
on personal circumstances. Simply repeat number 5 for each time frame required.)
6. Total Needs (1+2+3+4+5's
)........................................................................
_______
7. Total current investment assets to be used instead of buying additional
insurance. (Be aware that the current asset value may be considerably different
at time of liquidation and in fact may be significantly discounted due to
forced sale.) For example, perhaps the deceased had an IRA or 401(k)
plan that would immediately be utilized ..............................._______
8. Life Insurance needs (6-7) Repeat for
spouse.................................................. _______
This was not/is not easy to do. Rarely do consumers or agents go through this much effort in determining how much is really needed. Nonetheless, it represents the fundamentals to determining the amount of insurance you need.
But after all said and done- even if the numbers are all done correctly- most people still end up buying the wrong type of insurance. That's discussed on other pages.
An alternative approach to the amount of life insurance Anthony Steuer and Laurence Kotlikoff (2001)