How Much Life Insurance Do You Need?

I was surprised lately when I was speaking to a friend and learned they don't have any life insurance! We just automatically bought some when we had kids and I thought everyone else did the same. Looking into it some more I was shocked to find out that only 34% of people considered life insurance essential to their financial plan and only 40% of people bought it because of a life event, like having a baby.

I guess for a lot of people, deciding how much insurance coverage they need is a daunting task. And maybe people assume that the coverage they get through work is enough (usually somewhere between 2 to 5 times your salary). Well, you know me....I'm not happy until some math has been done, so let's explore different ways to figure out how much is "enough" coverage.

Firstly, there are a couple of things to keep in mind:

  • Don't assume that a stay-at-home spouse doesn't need to be insured. There are paid services involved with raising kids that aren't in the family's budget now, but might become expensive if a stay-at-home spouse dies. It's a worthwhile exercise to calculate what monthly expenses would cost more if that person wasn't there. Things like daycare, transportation, and the cost of meals might increase if the stay-at-home parent wasn't there to provide them.
  • Funerals are costly and it's much easier to deal with the stress of that unexpected expense when it's in the context of a hypothetical and unlikely event.
  • Straight-up life insurance policies are a better value and more flexible than dedicated policies that pay out in the event of death (i.e. mortgage insurance or credit card balance insurance). 

Now, when it comes to actually coming up with a number, consider these things:

  • How dependent the family is on the insured person's income. 

If there are 2 incomes in the household, can they each sustain all the monthly expenses on their own, without any dependence on the other salary? If not, then you need to assess what the deficit would be.

  • Will the family stay in the same home if one spouse dies? 

In other words, would the surviving spouse need to maintain the current mortgage and other household expenses on their own if tragedy were to strike?

  • What is the plan for managing the insurance money? 

For example, is the intention to pay off some major expenses with the life insurance policy and then have the surviving spouse manage all other monthly expenses on their own? Or alternatively, would the insurance money be invested and only the interest earned used to replace the deceased's salary on an on-going basis? Both are feasible options, but if the intention is to spend the money, make sure and calculate amounts needed for future large expenses as well (i.e. college costs or supporting aging parents).

Personally, I think a combination of those 2 strategies is smart. We figured out the amount of the salary we would need to replace in order to maintain the status quo in our house. We calculated how much we would need to invest in order to generate that amount, only using the interest and never touching the principal. Then we added the amounts we would need to cover certain large expenses off the top, like funeral expenses.

When you're calculating how much capital you need in order to generate a certain income, make sure that the numbers you use for estimating are conservative and align with your investing strategy. If you only intend to invest in no-risk GIC's, then you need to assume you will only be making 1 to 3 percent on your investments and you need to insure yourself accordingly. Alternatively, if you are a savvy investor and confident in your abilities to profit from your investments, you can probably use a number somewhere between 6 and 15 percent in your calculations.

Once you've found a percentage you're comfortable estimating with, you simply take the amount of annual income you need to generate from the investment and divide it by the percentage. This will tell you how much you need to be insured for in order to generate a perpetual income from the principal, without ever using the principal itself.

Ex: If you need to replace a salary of $50,000/year and you want to assume an 8% return on your investment, and you want to make sure the cost of a funeral is covered up front, then the calculation looks like this:

$50,000 ÷ .08 = $625,000 + cost of funeral – any life insurance payable by an employer = amount of insurance policy

Of course, life insurance is one of those things we buy hoping to never need it, but a little forethought goes such a long way. Most life insurance is very affordable, and really, how can you put a value on peace of mind?

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