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
September 8, 2010 at 6:52 am
Thanks for the info. Someone classified all insurance as a “grudge” purchase, but if you ever need it, it’ll be the best thing you ever bought.
September 8, 2010 at 6:54 am
Interesting. Based on that calculator I’d need over 2 million in insurance for my own pay cheque. I’m currently insured for the next 19 years at 1 million. maybe I need to re-consider my insurance options.
regards,
Jason
September 8, 2010 at 7:09 am
Excellent article!!!!…this is exactly how I try to explain it when talking about credit protection…if they don’t want to purchase the credit protection it’s fine BUT only if they already have enough other insurance in place…and the only way to determine that for sure is to do the calculations…I am going to save this example because it is so clear and precise…many thanks!!
p.s. the poll has not refreshed yet…it’s still last week’s poll
Also, I watched Princess last night…it was great!:)
September 8, 2010 at 7:11 am
Wow, that is extremely helpful, Thanks! You made it quite simple. We currently only have mortgage insurance, will this be good enough until we can switch to regular life insurance?
I watched the web exclusives for Princess (we don’t have a TV so I have to wait for them to put the full episode on Slice.ca). The Bridezilla one was hard to watch, painful. My entire wedding cost $6000, paid cash. I paid $2000, hubby spent $2000 on the ring and my dad paid $2000 for the reception. 23 people came, including the bride and groom and we had a first class event. As much fun as it would be to be a princess for a day, I prefer the idea of prudent financial planning so that in a few years, and every year thereafter, we can take a luxury vacation and be pampered for 2 weeks, all paid in cash.
September 8, 2010 at 8:00 am
Great article!
One thing Dh and I made sure we had when our first babe was born was adequate life insurance should something happen to one of us. When I looked at the amount our Insurance “Guy” had for my policy, I thought he was just trying to make a “sale”, so to speak. Then he explained it to me LOL.
As a stay-at-home-parent, my income is technically nothing…but if I were to die, Dh would have child care expenses, (I’d even say he’d need a housekeeper and cook, too…but I’m sure he’d manage
). I don’t know if a lot of SAHPs think of the value of the work they do each day, and what it would “cost” to replace that. I’ve talked to other SAHPs whose spouses have life insurance, but they don’t…because they don’t make any money they feel they don’t need to replace income if that parent dies. If the children are young enough to need outside care, where is the money going to come from?
Something to think about for sure!
September 8, 2010 at 8:33 am
As a single person – do I need life insurance? Hopefully this will be addressed in the next posts.
Missed Princess last night due to me starting out on a new business venture
Will check the episode out online when it is posted.
September 8, 2010 at 8:59 am
Eep! I had best re-visit my insurance now. I may be VERY underinsured! Watched Princess last night – can’t wait for more episodes.
September 8, 2010 at 9:00 am
@ Sparky – do you mean credit protection like credit card protection? That’s a terrible product if so, with heavy premiums for very little coverage.
@ Heidi – my personal opinion is the only reason you as as ingle person may want to get life insurance is to qualify now while you’re younger and presumably heathier than you will be in the future. Financially it makes little sense assuming you have enough networth to cover your funeral.
@ Jason – I had the same reaction and then I started to question the logic. Why would the mortgage remain in the scenario above? Assuming that a couple making $100K a year bought an at most $500K house, wouldn’t paying off the house in full immediately be better than paying out the interest on the mortgage for 32 years? Then you have freed up a lot of monthly expenses; also presumably the 2nd car if it exists could be sold, etc. I think the calculator grossly exaggerates how much you really do need. It’s also a personal opininion of mine that I dont think the living party should live forever and ever in the style they’ve grown accustomed to – so shorten that timeframe from 32 years to say 14 so the littleest one can turn 18 and then daddy’s back on his own.
September 8, 2010 at 9:13 am
This is very interesting. We have not purchased life insurance yet (DINKS), but since purchasing our first home in May have begun to have the insurance talks. We were pushed into buying mortgage insurance (which we later cancelled because of the brutal loopholes we found).
We haven’t done this yet, but our initial feeling about life insurance was that we would insure for just over the amount left on the mortgage (currently about 400k, so we’d maybe insure 500k). We have an income property in our home as well. The idea was that if one of us were to die, the insurance money would be used to pay off the mortgage immediately. Suddenly that $1600/month payment is gone from the monthly family costs, AND a massive chunk is saved on interest over time. Whichever one of us is left could easily survive on their sole income if our mortgage payment was no longer around (remembering that we also make $1000/month on our income property).
I see the argument of stretching the lump sum payment over the 32 remaining years, but would there not be value in paying off the mortgage faster and not needing as much money over time? Perhaps I’m not seeing an obvious flaw in our reasoning.
Thanks for running this series Gail – it is very easy to read and well explained!
September 8, 2010 at 9:14 am
I guess I should say that I do realize that we are not permitted to pay off the mortgage in one full sweep, but it could be done over a period of 2-5 years upon our death without penalty.
September 8, 2010 at 9:38 am
@Stephanie – we also have a SAHP and when we got insurance decided to insure both of us for the replacement value of the single income. For us, the ‘lifestyle’ for our children is that they have a parent stay home with them. Of course as the children get older the remaining parent would eventually go back to work, but at least until the youngest is 10 or so we would still have someone at home with them.
September 8, 2010 at 9:39 am
Any chance you could address age and getting insurance in one of the next posts? Or does anyone else have any insights? Right now, I don’t have kids or a home, and don’t imagine I will for at least another 5 years. However, I’m very healthy and I’m 26 years old. Should I be getting insurance now, while I have no dependants and am not yet married to my boyfriend? Or will it not make much of a difference if I wait until I’m 30?
I’m very excited to see a 3-parter on insurance: I’ve been so curious ever since a good friend of mine (my age) has become disabled, and it made me wonder: should I get insurance now, before something happens to me?
Also, I saw Princess last night, and it’s nice to see such an intense focus on one person. It really highlights how the ways in which one person decides to live their lives impacts so much on others. It also showcases Gail’s straight-shooting way of talking to people and getting to the heart of the issue. I have a feeling I’ll learn something from this show! :*)
September 8, 2010 at 10:10 am
The only insurance we have is thru hubby’s plan at work…..think it’s a lump sum of 3x his yearly salary. I’m at home, and not insured. We did get the bank’s mortgage insurance (looking back, we should have gotten another party’s lump sum type), but cancelled it close to the end of the mortgage. This whole insurance thing has often confused me (when they’re pushing the kind with the investment portion)….but it’s a question we really should sit down and discuss one day.
Looking forward to Princess…..hopefully it’s up on the web soon!
September 8, 2010 at 10:12 am
@ Jennifer – you could likely pay off your mortgage early but pay a penalty is what I think you meant. You’d have to see if paying the penalty would be greater than the interest you’d pay out (likely not).
@ Jessie – get a quote for today and then ask thme what the same would be for when you’re 30. Risk is assuming your health doesn’t change in those 3 years. Then see if the premiums you’d pay over the next 3 years are so much lower.
September 8, 2010 at 10:26 am
@ Stephanie – nice to meet another Stephanie poster!
I haven’t posted in a month or two because we’ve been super busy and my youngest is now 4 months and still using up most of my hours. We have completed 8 months of our debt plan and have 2 years and 4 months left to be debt free. We need wills and life insurance but like a lot of people have put it off because we are so focused on paying off the debt. What would happen to us if one of us would pass away? I also would think I would get re-married eventually but not so sure about my husband. That would affect the numbers.
As always Gail talks to me in my head so I have gone back to work a little each week to save up for next summer. I would like not to work full-time so that my oldest boy doesn’t have to go to daycare again before kindergarten starts next Sept. Trying to reduce expenses and save is hard enough but what if ‘the paycheque’ was gone forever?
September 8, 2010 at 10:48 am
Something to keep in mind for this calculator is that it is your NET income that needs to be replaced, not gross. Also, much as we don’t like to think about it, your income could very well get replaced anyways if your partner remarries. Not that I’m advocating against having life insurance, but something to consider.
September 8, 2010 at 10:49 am
This is a great article and is very easy to understand. Thank you for posting this! I’m looking forward to the following two instalments. I also really enjoyed watching Princess last night and hanging out online. Fun!
September 8, 2010 at 10:56 am
According to that calculator, I need to be insured for about $500,000. I’m currently insured for $375,000 – not too bad.
Hubby would need to be insured for $1,300,000. He’s currently insured for $800,000… not quite enough I guess.
Time to review our insurance needs. Very interesting article. Thanks!
September 8, 2010 at 11:46 am
What a timely article! I am completing my health questionare interview at lunch today for life insurance! I think the information presented is useful to be sure, however, something that isn’t discussed or mentioned is what the insurance will cost your household one a month to month basis. Using the calculator, my dh and myself would ‘need’ about 750000 dollars worth of insurance. We are both currently going through the screening process, but is my understanding that this type amount of insurance could cost between 30-75 dollar per month each. So that could be 150 dollars per month! I don’t know about most folks, but that is a lot of money from our budget (since we have a young family, kids in daycare, a mortgage etc.)
So for us that this point, our goal is to get the life insurance (so that we will be eligible in the future), but we sort of worked it backwards. We can afford about 50 a month, so we will get however much coverage that will buy us (I think around 250000 per person). So while we won’t be set for life, that amount combined with our workplace life insurance (2.5 X annual salary) will at least help. I think the above is the ‘ideal’ but as with most things money related, it is better to do what you can afford…and that is better than doing nothing at all.
September 8, 2010 at 11:49 am
@Geoff…no, no not credit card protection (I agree that’s a terrible product)…I mean mortgage, loan, line of credit…protection for your credit products…that is a good product and smart to have…and if you don’t want to buy the product from your lender make sure you have enough on your own…I have a good discussion about it with my clients…give them all the written material up front…have them check out the policy they do have and then they can make an INFORMED decision about whether to accept it or not…
September 8, 2010 at 11:55 am
I’ve read advise which suggested insuring for twenty times the annual amount that you would need. Then you can invest the principle at 5% and live off the interest. That’s probably a riskier option for the average person, though. You’d have to be very certain that your survivors could get a 5% return.
September 8, 2010 at 12:04 pm
This was an interesting article. The calculator I’ve still got some reservations about as it actually increases your income over each year your partner is using the replacement, and leaves quite a chunk for the last year you factored it in. Also according to the calculator, I’d need anywhere form 1.3-1.7 million dollars of coverage – much more than my $350,000 now.
Also – I am not a fan of Credit Protection – purely because the plans offered are quite costly and are simply a just-in-case measure for a job loss. Since Gail’s Army is a large proponent for not having consumer debt (which translates to “stuff debt”), I do not see the need for this Protection at all.
I’m very interested to read the rest of this series as Life Insurance is something my partner and I will have to reevaluate shortly. Plus with his line of work, Income replacement in the area of 75-90% is something we’d need to look at as he is in a trade requiring full use and dexterity of both hands, all fingers, and arms and legs.
Seems my list of things to do is getting ever longer with the financial items!
I was fortunate to watch Princess at noon and 4pm yesterday, and I like that the format is that of ‘Til Debt, but the drama these people bring is absolutely way more entertaining! From an “are you serious there are still people like this in the world” kind of way. Great show Gail! I love that there will be new episodes of Gail to watch – even if the name has changed, it’s like “Til Debt on a serious case of Hormones! Not only that but I like that you have to get a commitment from the friends and family as well – something that could have helped a bunch of the ’til Debt Families as well!
Keep it coming!
September 8, 2010 at 12:14 pm
Thanks for the information on life insurance. My fiancé and I recently bought a condo and are getting married next year, so this is definitely the right time to be looking into insurance!
I watched ‘Princess’ last night and it was great! I will be making sure to catch all other new episodes!
September 8, 2010 at 12:21 pm
@jessie : I would highly recommend buying insurance NOW, while you’re young and healthy, and the premiums will be the lowest. I’m also 26, but two years ago I got sick and now I have an unidentified chronic illness. No diagnosis means that no insurance company will insure me for anything more than about $20,000 – about enough to cover my funeral, but not enough to keep my son in childcare until school starts (he’s two). I’m insured (by a no-medical plan) for the $20,000, and also for about the same amount through my husband’s work for a small fee (also no-medical), but I really wish that I had bought insurance young, when I was still healthy, or at least didn’t have so many symptoms that no one would cover me.
So buy young, buy healthy, and buy now. Don’t wait – next year you might get sick, and not having any insurance can be a real pain. Also, don’t wait necessarily until you have dependents or a spouse – because a) you want to be able to pay your own death expenses and not make your family pay them (i.e. funeral) and b) pay your debts and pay off your estate. It leaves a lot less for your will executors to do.
September 8, 2010 at 12:34 pm
Jessie-it sounds like you’re more concerned about disability insurance, as in, what happens if you become disabled. You can insure your paycheque while you’re alive with disability insurance. I’ll let others, more knowledgeable than me on the subject, answer your other questions.
Geoff-I tend to agree with you about the length of time to insure. We don’t have kids, and if something happened to me, I’d assume that DH would move on and find someone else over time. If he could pay off the mortgage with the life insurance, and get rid of the second car we have to have right now, he would be very comfortable without my wage. I think kids change the picture significantly though-we would definitely bump up our coverage significantly if kids were involved.
September 8, 2010 at 1:08 pm
I don’t agree with the calculator.
Doesn’t it depend more on what your debts are.
I think as long as your insurance covers your debts and leaves a little behind for your family that is sufficient.
September 8, 2010 at 1:35 pm
When younger we started off covering ourselves in case of death/injury. Lots of insurance to take care of whoever was left to cope and raise our children. Had insurance on our LOC as well (long gone). Our children are adults.
Now, as we will be debt free Nov. 30th – we have enough insurance to bury us and leave a bit. Have a very good policy for while we are still alive and need assistance health-wise etc. Our investments will keep us afloat till the end.
With Gails nudge….. I spent 2 1/2 hours typing up all the information for ANY questions our children would need answered re: financial advisor, lawyer, all banking info. and accounts, funeral director, who to notify, and on and on.
So, with wills, power of attorney for health and finance, insurance, etc., etc. – I think we’re covered again.
September 8, 2010 at 2:02 pm
I have 3x my salary life insurance (as well as disability insurance) through my job, and don’t need more than that as I have no dependents and my mortgage is paid off. I have plenty of savings to cover my funeral and to pay for any expenses for disposing of my estate, so I’m not worried. But if I ever didn’t have the disability insurance from my job, that would be the first thing I’d invest in, since statistically one is more likely to become disabled than die at a young age I hear.
September 8, 2010 at 4:16 pm
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September 8, 2010 at 7:20 pm
The article is good, and the calculator is a good estimator, but some qualifications are needed.
The article suggests replacing GROSS income, which isn’t necessary. The ‘Annual Income’ should be NET Annual Income since you wouldn’t need to replace the portion taken by income tax as death benefits aren’t taxable.
As noted by others, it makes no sense to stretch your mortgage payments out. With a lump sum you would pay it off at renewal or sooner, depending on the penalty (if any).
One could assume a widowed partner would remarry at some point, which would reduce the financial obligation. If there are no kids, I’m sure Gail would agree that the partner would need to make lifestyle changes which would immediately reduce their financial requirements (e.g., sell the house, no second vehicle, no Caribbean vacation, etc.).
The impression Scenario 1 leaves (that full income replacement is required for 30+ years) would cause someone to spend much more on insurance premiums than necessary. I would suggest the most appropriate amount would be the amount required to immediately pay off the mortage and any other debt, invest some for the kids’ education funding (if you have kids), and some allowance for modest living expenses in the short term (2 years).
September 8, 2010 at 8:18 pm
@Geoff – thanks for your input !
September 8, 2010 at 9:10 pm
1) Gross income is correct.
Gross income is taxable. In the calculator, see the column “interest earned on insurance proceeds”. That’s going to be taxable as well. Those two taxes are going to be roughly equivalent.
One could change the calculator to use net income and tax the investment earnings. Doing so increases the complexity of the model without increasing the accuracy. In fact, it worsens the accuracy. Keeping fewer variables is important.
2) Mortgage pay down.
How to invest after the fact is a different question than ‘how much’. That question is not addressed in the article, in fact you would normally address it after you have the insurance proceeds.
Should you pay down the mortgage? Invest in indexes? Top up RRSP’s/RESP’S with the insurance money? Maybe,maybe, and maybe. But these questions are not knowable ahead of time precisely. Again, they increase the complexity of the model without increasing accuracy.
I’ll illustrate the general impact. You take $500,000 of insurance and use it to generate $50,000 of income, out of which you continue to pay your mortgage. Or, you pay your $200,000 mortgage which leaves you with $300,000 of insurance left – and that now only gives you $30,000 of income. Either way won’t materially affect the fact that you originally needed about $500,000 of life insurance.
The calculator is not intended to provide an exact answer. In fact I don’t believe there is an exact answer for most of us. Use it with different assumptions to give you a range of reasonable. What we want to find out is that something like $500,000 to $750,000 is where you should be, and not end up with $250,000 and thinking that’s enough insurance. Once we know the range is $500,000 to $750,000, then your judgement as to where in that range you should go is a personal decision and not a mathematical one.
September 9, 2010 at 8:51 am
great post… The easiest way I think would be to use an online life insurance needs calculator. This calculator will take various aspects in to account, aspects such as inflation rates and the value of all your current assets. These will provide you with very accurate feedback as long as you provide it with the correct information.
September 9, 2010 at 9:26 am
“however, something that isn’t discussed or mentioned is what the insurance will cost your household one a month to month basis”
Something that isn’t discussed or mentioned…..yet. Stay tuned for article 3
.
September 9, 2010 at 4:25 pm
Husband is 63 in May, I am 58 in Jan. He has a policy for 1 mil that costs $350. a month. We 1/2 it last april from 2 mil because it was costing us 865 a month. This was set up at another time in our lives.
When he is 65 it is going to jump way up.
Right now he is in proposal situation with trustee.
There is no money or savings at the moment. We are living day to day.
I am unemployed. Kids are 14/18/21. What type of insurance can we get or should we have.
September 15, 2010 at 8:01 am
@ Mary
Seems like you have term insurance.
One of the problems with term, is sometimes trying to be self-insured helps but it is always nice to have a mix of both.
Your situation sounds tough and without cash flow you have limited options.
November 28, 2010 at 6:16 pm
Good article. It’s important for people to know that when figuring out how much insurance you need, you should consider a lot more than how healthy you are. You also need to consider factors like your job’s security and your income.
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