I spend a great deal of time helping clients work through retirement and investment plans. I love talking with them about future goals and ways to achieve them. However, I don’t love helping clients think through what happens to their family if they are in a fatal accident tomorrow. It’s not fun for me or for the client. People can get very emotional at the mere thought of their husband or wife dying, so most people try to avoid this type of conversation like the plague.
But, speaking as someone who has experienced an immediate family member passing way too early, it’s just too important not to discuss. I think we can all acknowledge that we want to protect our families, even though it’s uncomfortable and difficult to talk about, so let’s answer some questions.
How does a surviving family actually use life insurance?
I think all of us want to do the right thing for our families, but the facts indicate that many of us don’t take the steps to ensure that our family is protected. A report from LIMRA in 2017 states, “Fifty-four percent of Americans own some sort of life insurance (individual and/or group). While the mean life insurance coverage amount equals $168,000. This amount equates to 3.4 years of income replacement.” (I’ll save you the math calculation. That equates to $49,000/year for those 3.4 years. That’s about half of the median household income here in Mount Pleasant.)
So based on these statistics, 46% of the population has no coverage and those that do only have enough death benefit to replace 3.4 years of income at $49,000. I think the low coverage amounts cited by LIMRA are not because people don’t care about their families. I think folks just don’t really understand why they need life insurance or how the insurance proceeds will be used to benefit their family.
In short, life insurance provides a sum of money that can be used to protect the financial lives of our families. Specifically, life insurance exists to cover a potential estate tax problem, to have a tax advantaged investing vehicle, to cover the cost of a funeral, pay off a mortgage, cover college expenses, children’s future weddings, and, most often, to provide income for the surviving family. The idea isn’t to set your family up to live on “Easy Street” when you pass away, but to cause as little financial hardship to their lives as possible. Your family will be distraught mourning your loss. The last thing you’d want is for them to be burdened with worry, wondering how they will survive financially.
So how much life insurance do you really need?
This is, by far, the question I’m asked most when it comes to life insurance. Most people know that they need it. They just aren’t sure how much.
We can agree that life insurance’s primary purpose is to replace your potential economic benefit to your family. If you think about it, financially speaking, it’s similar to retirement. Either way, by death or retirement, your potential to earn and save on behalf of your family has gone away.
I am 40 years old, and I likely have 25 or so more years before I will consider retiring. If I retired tomorrow or simply stopped working, my family’s finances would change drastically. So if you were to think about Life Insurance coverage that way, ask yourself, how much money would you need to stop working tomorrow? That amount of money is probably how much you would need in Life Insurance protection. Retirement goals change as your assets grow and as you get closer to retirement. Your life insurance needs also change over time.
The flawed - yet common! - rule of thumb
As a starting point, many advisors start with a basic rule of thumb that you should have at least 10 times the amount of your annual salary as a death benefit. I do not agree with this, and I’ll show you why.
Let's look at an example:
Bob is 45 years old and single income provider for his family.
Bob’s annual salary is $100,000 (75% used for household expenses with the remaining 25% going to savings and taxes).
Based on the 10x annual salary rule of thumb, Bob purchase life insurance coverage for $1,000,000.
Unfortunately, last week Bob was the fatal victim of an overly aggressive driver during the morning rush hour. After the funeral, Bob’s wife, Susie, called the life insurance company and they issued her a check for a tax free life insurance benefit of $1,000,000.
Being wise, Susie and her children immediately took the $1,000,000 to a financial advisor to ask what to do with the money. The advisor said that because the money needs to last for a very long time, he can only safely distribute 4% of the portfolio per year to Susie. That means Susie and her children will now receive $40,000 per year. ($1,000,000 x 4% = $40,000).
That doesn’t sound so bad, because it’s way better than $0, but let’s go back to the annual household expenses. Not including savings towards retirement, college, taxes, etc., the household expenses, as you will recall, were $75,000. So here’s the problem:
($75,000) Household Expenses
- $40,000 Life Insurance Income
($35,000) Shortfall
So, in this example, something has to change. Their lifestyle would have to be reduced by $35,000 per year or 47%. The point of this example is not to argue whether they should pay down the mortgage, or to illustrate that Susie would have to go back to work. It is to point out that the lives of the surviving spouse and children would have to change dramatically.
This example also assumes no taxes, no future savings toward retirement, college, etc. If we factored that in, their lifestyle reduction would be much more dramatic. But, again, I’m trying to keep this simple to make this point: the 10x salary rule of thumb is not a safe bet. If you’ve been using that one, or if that just happens to be the amount of your life insurance benefit, it’s probably time to re-evaluate.
Do I have too much?
Insurance guidelines usually state that if you are 40 years or younger, you can get up to 25 times your current annual income to calculate the most you can be insured for. For each ten years of increased age, the multiple is reduced by 5. So at age 50, you can be insured up to 20 times your annual income. This would be considered the maximum, and for most people, this would be too much.
So how do you figure it out?
Let’s go back to the idea of thinking about retirement. How much would you need to retire today? You probably need about the same amount in life insurance. For those of you that want a quick calculation, try this one below. It will give you an idea if you are in the right ball park.
Current annual salary x 75%
4%
For example:
$100,000 x 75% = $75,000
75,000/4% = $1,875,000
My hope is not to help you determine the perfect formula to calculate life insurance coverage in a blog post. My goal is to help you see if you may be over or under-insured, and to spark a conversation. Personally, I avoid using general rules of thumb with my clients and instead take a more comprehensive review of the family's needs. Talking through insurance coverage is a standard part of our planning process. If you would like to discuss this and many other planning items, send me an email today. I’ll have the tissues handy in case things become emotional.
Until next time,
P.S. If you've gotten the impression that I'm only addressing the men, you should know that as soon as my oldest child reached 20 weeks in the womb, even though she wasn't working at the time, my wife insisted I have life insurance on her. My wife's reasoning was that if something happened to her, there was a certain level of care she wants for me and our children through their college years, and the reality is that there's a high cost associated with that if it is hired out. If my wife meets an untimely death, I will be able to hire a high quality nanny, have meals prepared, and maintain our current quality of life from a financial standpoint. It's not about us living a cushy life when she's gone. It's not about finding someone to replace her. It's about her peace of mind that we will be well cared for in the most basic ways if she's not around to do it herself.