Tips to cut through the confusion
Unpredictable investment and job markets can be rough on retirement planning. They also complicate the issue of how much life insurance is appropriate for you.
Standard formulas — such as buying coverage equal to eight to 10 times your annual income — are inadequate shortcuts. Online calculators are apt to tell you to raise your coverage by $1 million even if you already have insurance. The truth is that life insurance is a personal affair. Two couples may earn equal salaries, but someone with four young children will have different needs than empty nesters with no mortgage and a substantial retirement fund.
Low inflation and a recovering stock market may tempt you to low-ball your life-insurance needs. But other financial realities, such as a low yield on reinvested lump-sum benefits, may require that you have more coverage, not less. And you’ll likely experience life events that call for changes in your insurance: marriage, parenthood, homeownership, college expenses and retirement. Instead of relying on rules of thumb, consider a systemic approach to figuring your life-insurance needs.
To calculate how much coverage to buy, and to form a plan that’s easy to update, assess whether you need extra coverage or different policies only after you project your needs as the sum of the following four categories:
1. Final expenses. A funeral, burial and related expenses may cost $10,000 to $20,000. Your beneficiaries may be able to get the tax-free proceeds from insurance faster than if they waited for money from your estate. Use $15,000 as a ballpark number.
2. Mortgage and other debts. Total your mortgage balance, car loans, student loans and any other debts that would be a heavy burden on your survivors. They may choose not to retire the mortgage, especially if the interest rate is low, but the money should be available so that they won’t face the prospect of being forced to sell.
3. Education expenses. This calculation can be tricky because you need to consider the cost of college at the time your kids enroll. Though no one can predict what college might cost in five, 10 or 15 years, annual price increases in the range of 4% to 7% would certainly be in keeping with historical trends. If we assume (hypothetically) that life insurance proceeds grow at about the same rate, one method would be to look up current costs for colleges you might consider, apply a 5% rate of inflation and decide whether you’d want the insurance to cover all or a portion of the tab, and add that amount in today’s dollars to your insurance needs calculation.
4. Income replacement. Once you cover funeral expenses, debts and education, your family likely won’t need to replace 100% of your income — and that’s where the art part of the calculation comes in. Consider covering 50% of current pretax earnings until retirement. You can translate this into a target lump-sum benefit by dividing by 0.05. If you earn $100,000, divide $50,000 by 0.05, which works out to $1 million. That assumes the insurance benefits will earn 5% a year over the long haul. This is a hypothetical example and is not intended to reflect the actual performance of any investment.
Add all four categories to estimate how much life insurance is appropriate, then tweak the number to reflect personal circumstances. You might increase it if you don’t have a pension, but you could decrease your coverage if your spouse earns a substantial salary. If you or a family member has a troublesome medical history, add $100,000 or even $250,000. If you’re the one with the medical condition, you’ll find it tough to buy additional coverage later at a price you can afford.
For most families, this exercise will work out to an amount in the high six-figures, possible even $1 million or more. But with term insurance, boosting your death benefit by hundreds of thousands of dollars should cost just a few hundred dollars a year.
The Time Factor
Also consider how many years you’ll need insurance. If you’re in fine physical shape, you can buy a new policy and lock in the price for 20 years. You may not pay more to extend your coverage if you reshop in, say, five years.
Some term policies come with the right to convert to permanent life insurance, which you can keep for the rest of your life regardless of health. Premiums for permanent life insurance will be higher than for term at the beginning, but they usually remain level indefinitely. The best reason to consider whole-life or universal-life insurance isn’t the accumulating cash value, although that’s part of the deal. The real issue is whether you’ll need coverage beyond 20 or 30 years — or after age 65, when term gets expensive. You might want permanent insurance, for example, if you need to protect kids with special needs who will always rely on you (or your estate) for support, of if you want to leave money to a school, charity or your children and you don’t expect to afford it any other way.
You may need more life insurance if you …
- Tie the Knot. Your new spouse might depend on you even if he or she earns as much or more than you do.
- Have a Child. It takes a lot of money to raise a child — and it doesn’t get any cheaper if you’re not around.
- Buy Your Dream House. When you settle into your family’s permanent home, guard against its loss in case tragedy strikes.
- Are About to Retire. No more insurance from work. If you die, your spouse could lose pension and some Social Security income.
Term vs. Permanent: Get the Best of Both
Term insurance is popular because almost everyone can afford it. Some young people buy the amount of permanent insurance that fits their budget, rather than the protection they need. That’s not necessarily the best move. But it can make sense to combine term and permanent insurance with multiple policies or by buying a convertible-term policy and making a series of conversions over the years.
Here’s an example for a 27-year-old man in good health. Let’s say he starts by paying $164 per year on a 10-year, $500,000 level premium convertible-term policy (where premium costs do not increase for 10 years). He could also opt for a 15-year level policy, a 20-year level policy, a 25-year level policy, and so on.
At any time before he reaches the last conversion date (age 70 in this example), he can opt to convert all or part of his $500,000 coverage to a permanent plan that offers level premiums for life, without having to take a physical exam. Say at age 31 he wants to convert $100,000 to permanent insurance. The annual premium would be $580 on that permanent insurance amount.
An often-overlooked benefit of owning convertible term insurance is this right to move to a permanent policy without an exam. Be sure to check when the latest possible conversion date is — because once that date passes, there is no other opportunity to convert.
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