How much life insurance do you need, exactly? How do you determine how much is enough? Is there a life insurance rule of thumb? Are there limits to how much you can get? And if you are using a whole life policy, is it really providing you the death benefit you’re entitled to?
These are the questions we hear all the time, and it’s understandable. With so much information on the internet, what can you trust?
First of all, we’d like to clarify that no one “needs” life insurance. It’s not a staple of life like food, water, and shelter. And we are definitely not in the business of applying pressure or guilt to buy life insurance. That being said, many of our clients WANT life insurance!
There are many reasons to want whole life insurance. Some people desire the many benefits of cash value insurance to use while they’re living. Others desire the protection and certainty that a death benefit provides for their spouse, children or grandchildren, and even business partners and employees. And some people want all the benefits!
How Much Life Insurance Should You Have?
If you’re on board with the benefits of insurance, we think the better question is how much life insurance SHOULD you have? This is an arena in which everyone has their own opinion, so you’ve got to wade through lots of methodologies to find your perfect answer. Here are a few such methods, how they work, and why we don’t recommend them.
The Needs Approach to Life Insurance
The needs approach to life insurance, also called needs analysis, is one of the most common approaches to buying life insurance, and one of our least favorites. The needs analysis suggests that you should look at all of your financial liabilities (including future ones like children’s college tuition), and add those up. In other words, you should only think about what you’ll NEED to pay for. Then, of course, you want to tack on potential funeral costs. If you do this, you should be fine, right? Your family will be able to pay off the house, the cars,and the funeral.
The problem with this approach is that it’s so limiting. It doesn’t provide you or your family with any wiggle room. And death can often come with a lot of surprises. By only endeavoring to fund the bare minimum, your spouse couldn’t take time off of work if they wanted the space. And what happens if an expense pops up that you didn’t account for? What if inflation makes your death benefit insufficient? The needs approach to life insurance doesn’t account for any of this, and can often lead to your family being underinsured.
The DIME Method
The DIME method, like the needs analysis, is all about estimating what your family will need when you pass. DIME stands for debt, income, mortgage, and expenses. By adding up the numbers in these categories, you’re meant to arrive at a “sufficient” amount of life insurance. Once again, we’ll suggest that you’re undercutting your family if this is the case. Expenses will rise and fall, education costs will only go up, and you might actually be selling yourself short if your don’t multiply your income by a high enough factor.
Multiple of Income Approach
This method is getting closer to the heart of the issue, though it’s still possible to fall short of how much life insurance you should have. This is simply because people don’t multiply their income by a high enough factor. Traditionally, a woman earning $60,000 per year might calculate that she needs coverage equal to ten times her salary, or $600,000. While this method is simple, it has shortcomings if multiples are too low.
For example, this multiple doesn’t measure non-wage value, and it also ignores potential wage increases. It also neglects factors such as debt (including a mortgage) and dependents. If you have children who will need a nanny if one spouse passes away, or who may wish to attend a public or private college, you’ll also want to factor that into your calculations. You don’t want to choose a random multiple of income, in this case.
The Sky is NOT the Limit on Life Insurance
While many of the above methods may leave you under-insured, It is important to understand that there is a LIMIT that insurance companies will not insure you beyond. If your spouse is making $30,000 a year and you wish to insure them for $20 million, you’re not going to find a company that will write that contract.
This is to say, you cannot buy too much life insurance. The insurance companies simply won’t let you. And this is where we come to one of our favorite approaches to life insurance. Because the companies have to be able to calculate how much you’re entitled to somehow–they don’t just pull the number out of thin air. And that’s where we want to start. After all, while you may not get approved for that $20 million, do you really want less coverage if you CAN get more?
This approach is called “Human Life Value” (HLV). This is the same method that courts use to award judgments in wrongful death lawsuits. While Human Life Value can be a bit more complex to calculate than the multiple of income method, it’s also considered more accurate.
Human Life Value Method Example: How Much Life Insurance Do You Need
Human Life Value method is defined as the “present value” of all future income that you could expect to earn for your family’s benefit, plus any other values you expect to contribute. Subtract from this any taxes and personal consumption. We’ll demonstrate with an example.
“Jane” is age 40 and wants to retire at age 60. She currently earns a salary of $60,000, of which 20% goes for her own personal living expenses and the other 80% for her family. Also, she provides an additional $15,000 per year of non-wage value to her family. (Think of this as the cost to hire a part-time domestic worker to perform her duties.) April’s total value to her family at age 40 is calculated as follows:
The next step is to increase this $63,000 for inflation over the next 20 years, to the date of her desired retirement. At a 3% rate of annual growth, her value would increase to $113,785 by age 60.
The last step is to apply a “discount rate” to each year’s projected total value, accounting for the time value of money. For example, at a discount rate of 4%, the total present value of Jane’s projected value through age 60 is well over $1 million. That is the amount of life insurance protection her family needs to adequately replace Jane’s earnings and insure against her death.
A Faster Human Life Value Calculation
Sound complicated? Here’s a shortcut! A simpler way to determine the Human Life Value calculation is to apply a simple underwriting guideline that life insurance companies frequently use to suggest coverage amounts. In general, your HLV is a multiple of your salary over your working years. So if you’re 30 and want to work at your current job until you’re 70, your HLV would be roughly 40 times your salary.
So for Jane’s circumstances above, we could simply multiply her base salary of $60,000 by 20 years, and know that she is entitled to $1.2 million of death benefit. If she had simply calculated her “needs” she might think she can only get a few hundred thousand dollars.
What About Business Owners or Non-Working Spouses?
If you own a business, the insurance company will have no problems insuring for the full estimated value of the business (plus HLV, if you have a separate income). If you own a business or rental property in addition to having a job (many real estate investors have day jobs), you will want to include that income as well.
Spouses who don’t work outside of the home are often calculated at 50% of their working spouse’s insurability. Oddly enough, having children and owing debts doesn’t necessarily increase your insurability by much, but it DOES increase how much insurance you may want. Not everyone will be comfortable getting their entire Human Life Value in coverage, but we recommend getting close to it.
The Top Down, Bottom Up Approach
Identifying your full Human Life Value is the first, and ideal, step to getting your insurance desires taken care of. By knowing how much you’re entitled to, you have a frame of reference to work toward. This is the “top down” view, so you have a great starting place. However, depending on your expenses, it may not be entirely realistic to purchase your full HLV in whole life insurance.
That’s where the bottom-up approach comes in. How much money do you have available to save each month? What do you WANT to save each month? What can you afford? Do you have other accounts you want to save from? All of these questions can help you determine the amount of life insurance you are actually going to buy. Yet knowing what you CAN get has to come first so that you can get the coverage you’re comfortable with.
For example, let’s say Jane from our HLV example wants to get that $1.2 million coverage. She sees the value it could provide to her family and heirs, and she knows that with PUAs her death benefit will actually grow over time. However, Jane can’t afford the full premium that entails. Instead of giving up, Jane can funnel as much money as possible into whole life insurance, and then cover the rest with term insurance. Even better, she can buy a convertible term insurance policy, which will allow her to turn the policy into whole life insurance if she wants. That way she won’t have to go through an exam again.
By taking this approach, Jane gets her full $1.2 million death benefit. While she may have less cash value potential to start because she has a smaller whole life policy, she can convert the term policy into whole life insurance over time, boosting her cash value.
What KIND of Life Insurance Should You Buy?
With the “Top Down, Bottom Up” approach that we’ve identified, the basis is whole life insurance. That’s because a properly designed whole life insurance policy, with a mutual company, is a savings vehicle as well as a protection asset. The money you contribute in premiums directly impacts your cash value account, which is the liquid savings component. This cash value is like the “equity” of your death benefit. The more premiums you pay, the more of the total value you have access to via cash value. And in a dividend-earning policy with the correct riders, your death benefit also increases over time.
However, not everyone can fully insure themselves with whole life insurance, depending on your monthly cash flow and other assets. That does not, however, mean that you cannot fully insure yourself. Term insurance is temporary insurance that can help you bridge your coverage gaps, so you are insured up to your full HLV. If you have a spouse or children, you might want to have as much insurance as you’re entitled to.
What About Other “Permanent” Insurance?
We do NOT recommend ANY other kind of permanent insurance other than whole life with the proper riders. Universal Life and other insurance policies correlated to the stock market are unreliable. The added risk not only defeats the purpose of having insurance, but when the market takes a downturn policyholders may find their policies underfunded and in jeopardy!
What If You Already Have Whole Life Insurance?
You’ve got a head start! If you have a whole life policy, you’ll have some permanent protection (assuming your policy stays in force). If you have a whole life policy in place, you may already be implementing Live Your Life Insurance or Perpetual Wealth strategies. You may even be a business owner or real estate investor who wants a substantial fund for emergencies, opportunities, and cash flow flexibility.
In other words, the death benefit may be more of a “bonus” for you, rather than the main appeal. However, the death benefit is a critical benefit nonetheless.
It is essential, however, to assess how much life insurance coverage you may WANT, in addition to the protection that a permanent policy provides. This may be a non-issue if you have no dependents (unless you have charities, foundations, nieces, nephews, or an alma mater that you wish to gift with a legacy). However, if you have children or spouses who depend on your income, even grown children or grandchildren that you wish to leave something to, then an adequate death benefit is probably worth your time.
Can We Help You Get Coverage?
Would you like help to identify what insurance you’re entitled to? Do you have an idea of how much you’d like to save and want help automating it? We’d be thrilled to help you with life insurance policies that give you exactly what you want. We invite you to connect with us here, or email your questions to firstname.lastname@example.org.