How much life insurance do I need?
Posted by gcooke | Filed under Insurance
Glenn Cooke offered to do a series of blogs on life insurance. This is one of those areas of personal finance that people most misunderstand, and I jumped at the opportunity to have an insurance specialist give y’all the lowdown. So here is Part 1 of Glenn’s 3 part blog. Part 2 tomorrow.
For most of us, getting life insurance seems to be even more complicated than finding the right cell phone plan. Different types, cash values, did I get the cheapest rates, it’s a very confusing process.
But it doesn’t have to be that way. If we break it down into small steps things become a lot less complicated. In fact, getting the right life insurance is a simple three step process.
- How much life insurance do you need?
- What type of life insurance do I need?
- Shop and review companies and products, with specific do’s and don’ts.
We’re going to address these three steps individually. Let’s start off with answering the question ‘how much life insurance do I need?’.
Before we determine how much insurance you need we need to determine ‘intent’, or what you’re trying to get done with life insurance. For our example let’s use an old-school nuclear family of:
- Mom, age 33, income $50,000
- Dad, age 36, income $50,000
- Two kids aged 4 and 6
Should Mom or Dad die, what they want is for things to stay mostly the same at home. They want the kids to live in the same house, eat the same brand of peanut butter, and Mom or Dad to drive the same car. They don’t want anyone getting rich off their death but they don’t want anyone going broke either.
Let’s examine that intent a bit more closely. What they’re attempting to do here is maintain their family’s standard of living should they die.
That raises the question where does the money come from right now to maintain their standard of living? Where does the money come from to pay the mortgage, put gas in the car, buy the peanut butter?
The answer to that question for most of us is our paycheque. It’s our paycheque that provides our standard of living. And that’s the cold hard fact of the matter; from a financial perspective, all that most of us are is our paycheque. And should we die what we lose from a financial perspective (not from an emotional perspective, that’s a different matter) is our paycheque.
So if we use life insurance to provide a ‘new’ paycheque should we die, then our family can maintain our current standard of living. In fact, what we’re really insuring here is not our ‘life’, it’s our paycheque.
Aside: This let’s us focus on the actual financial loss when a wage earner dies. We die, we lose our paycheque. If we die, do we lose our mortgage? Nope, there it is, due every month just like before. Because the mortgage doesn’t change upon our death, it’s not something we should be tying insurance directly to. What changed on our death was how we pay for the mortgage, and once again that’s our paycheque.
Let’s use Mom as an example to determine how much life insurance we need. Mom’s making $50,000 per year. We expect Mom is going to live a long and healthy life and she’s going to earn an income until she’s about age 65, or for another 32 years. That’s what we’re protecting with life insurance – $50,000 of income for 32 years.
At the bottom of this article is a calculator that determines the present value of a paycheque. Let’s use the calculator below to see how much life insurance she may need.
- her income is $50,000
- we’ve gone from 4 people to 3 so we don’t need the full $50,000. Let’s assume 60% of the $50,000 will be enough to maintain the family’s standard of living.
- Years will be 32 since for complete coverage we want to use same timeframe that we expect she’ll actually earn the income.
- Let’s assume inflation at 3% and interest at 5%. Use whatever numbers you feel comfortable with.
Put those numbers into the calculator and we get $723,834.17. Let’s look at what this means. The insurance company gave Mom’s family $723,834.17. Dad didn’t run out and spend all that, he put it in a savings account at 5%. Dad then withdraws $30,000 from that and puts it in their chequing account (that’s the 60% of Mom’s $50,000 paycheque). They live on that $30,000 plus Dad’s paycheque for the year.
Did anyone get rich here? Not at all. Dad and kids have maintained the family’s standard of living and that’s it. They simply used $30,000 for that year to maintain their standard of living.
Dad continues on, withdrawing $30,000 every year to live on for the next 32 years. Nobody gets rich, everything stays the same financially. We’ve increased the paycheque by inflation each year, which is what we would expect Mom’s paycheque to do over time as well.
Now look at year 32. The final paycheque is withdrawn and spent on maintaining our standard of living. And how much is left? $0 Almost $750,000 of life insurance has been spent on doing nothing other than giving us a $30,000 paycheque over a period of time. $750,000 of life insurance, and nobody got rich.
So let’s look at a second scenario. Rather than providing an income to age 65, let’s just get the kids out of the house. Once the kids are gone, Dad’s on his own. The youngest child is 4 so lets say we need a replacement paycheque for 20 years – that’ll be long enough for the youngest to be through school and into the workforce.
Same calculator, with inputs of $50,000 income, 60% needed, 3% inflation and 5% interest, and we end up with an amount of $502,890.68. Again, $502,890.68 will provide an income of $30,000 per year for 20 years and then there’s no money left.
So how much insurance does Mom need? Somewhere between $500,000 and $750,000 would be where Mom should be looking. That seems like a lot – and it is. The real underlying reason Mom needs that level of coverage is because we’re duplicating a paycheque over a long period of time. For younger families, it’s the length of time that drives a big part of how much insurance we need.
(note that the insurance company will still pay any death benefit as one lump sum, not in a series of paycheques. Dad would determine how best to split the money after the fact. The calculator doesn’t tell us how to spend or invest, it let’s us estimate how much insurance would be reasonable.)
Now let’s recap. What we’ve done is refocused our life insurance needs onto the actual financial loss we suffer should Mom or Dad die – our paycheque. And we’ve determined that Mom should have between $500,000 to $750,000. And while that seems a lot when you look at it that way, when you stretch that out over the years the kids are growing up the reality is it’s barely enough to keep things where they are now.
In the next article, we’ll be discussing the best type of life insurance for you and your family.
Glenn Cooke is an independent life insurance broker and president of Life Insurance Canada He can be reached at (866) 662-5433.
How much life insurance do I need? calculator