Life Insurance – How Much Is Enough?
What would happen if you died today? Would your family have enough on which to live? Would they be comfortable in the future or, in time, destitute? Conversely, if not unlikely, would they live opulently compared to now?
If you are like most, thinking about life insurance is not something you really care to do. Chances are the thought of your own mortality is not a pleasant subject for you, much less the thought of spending money now on something that has no benefit, at least tangibly, until after your departure.
But while your family's financial security is partly dependent on your investments, life insurance is also an important element, and one that is all too often overlooked and under planned for. In fact, according to The LifeJacket Study by Genworth Financial, "Over 42% of Main Street Americans do not have life insurance." Further it stated, "Even for those who do own life insurance, 40% recognize that they need more."
Alarmingly, according to a 2010 study by LIMRA, the average American only has enough life insurance to cover 3.6 years worth of income. But how do you know how much life insurance is adequate?
Determining this is no easy task. An industry standard of roughly 10 times your annual income is one yardstick, and certainly better than no planning at all. But is that really good enough for your family?
Determining the right amount of life insurance your family really needs is dependent on many factors, such as your marital status, age of your children, how much you and your spouse (if working) earn, other obligations you have, etc.
Too little insurance, and your family could be forced to dramatically alter their lifestyles at a time that is already filled with stress and grief. I think most people would agree that they would never want to leave their family faced with possibly having to sell a house, forego college, or having a stay at home parent go back to work due to lack of resources, for example.
On the other hand, having too much insurance can be a financial mistake as well. The main point of life insurance is as a hedge against premature death. Carrying excessive amounts of it is frankly a waste of hard earned money on something that odds are will not happen.
The approach to take is to calculate the life insurance amount that will provide the necessary income to meet your family's long-term needs. To do this, first determine the amount of your family's annual living costs. For this exercise, let's assume that number is $75,000.
One important caution here; don't forget the value of what you do, i.e., how much would your family have to pay someone to do some of the things you do for it for free. If something were to suddenly happen to you, your family might have to hire others to take on some of your daily activities.
You'd be surprised at how all you do adds up; things such as childcare costs (or costs for the care of parents), home, lawn and auto maintenance, financial services and tax preparation, and housekeeping. All of these need to be taken into account.
Next, determine other sources of income that are available, such as your spouse's earnings if any, investment income and retirement income. For our purposes, assume this is $30,000. That means you need to replace $45,000 of income to meet your family's needs ($75,000 minus $30,000).
Finally, estimate an average annual rate of return that you think could be achieved if the life insurance amount were invested in income-producing assets. This obviously is subjective and can vary based on many things so choose carefully. For now, let's assume that is 4.5%.
To determine the amount of life insurance that will cover your family's income needs, divide the net income needed, $45,000, by 4.5% and the result is a cool $1 million of life insurance that is needed to replace the lost income. You also may want to add more coverage for certain major expenses such as funding a child's education, paying off a mortgage, and those kinds of things that are not part of your current spending pattern.
This is just one methodology for determining the amount of life insurance you need, and a simplified one at that. Many websites have calculators you can use to help in this determination such as www.life-line.org and www.smartymoney.com, as well as most major life insurance providers.
Life insurance is a key element in providing financial security to those you love if something were to happen to you. Doing some legwork now, and reviewing your coverage regularly, can help avoid much heartache later on during a difficult time, and can be one of the best gifts you ever give your loved ones.
