Life Insurance. How much is enough?

Author: Gary Foreman

Hi Gary,
How much life insurance should a couple with two small children have?
- Anita H.

While none of us like to think about it, Anita is wise to be concerned with life insurance. Should either or both parents die insurance could be vital to her children's well being.

There are two basic methods Anita can use to decide how much insurance she needs. One way would be to replace the income of the deceased. A second method is to buy enough insurance to cover your expenses.

Your choice will depend on your present financial situation. If you struggle to pay your bills, look at the expense method. Otherwise replacing the lost income should be sufficient.

There are calculators that will do the numbers crunching for you. But unless you understand the process, it's hard to know whether they're giving you a good answer.

Anita doesn't need a perfect answer. To get that would require seeing into the future. She'd need to know her longevity, investment return, and future inflation rates. She can only estimate those things. So just try to get reasonably close.

First we'll look at using life insurance to replace income. We'll assume a family where only one parent works. That way we can do one illustration when you lose a spouse who draws a paycheck and another one for the person that works inside the home.

In most cases, you'll want to replace all of the income that's lost when an employed spouse dies. To be more precise, you'll only want to include the after tax pay and make adjustments for expenses (like a second car) that are incurred earning that income. Don't forget to add the value of health insurance or other employee benefits to the income number.

Now Anita has an amount of income that she needs to replace each year. But life insurance is often paid off in a lump sum. We're going to assume that she'd invest the life insurance proceeds and spend the income that it generates.

How can Anita calculate how big a lump sum she'll need to create a specific annual income? The calculation is simple division. Take the amount of annual income you want and divide it by the investment return you'd expect to earn on the lump sum (i.e. life insurance proceeds).

For instance, if Anita needed $50,000 a year and thought that she could earn 5% on the money, she'd need a lump sum of $1,000,000 ($50,000 divided by .05 = $1,000,000). That $1,000,000 would provide $50,000 to spend each year without touching her principle.

The investment return that you use will make a big difference in the calculation. For instance, if she assumed a 7% return, she'd only need $714,000.

What rate should Anita pick? Probably something between CDs on the low end and the long-term stock returns (6 to 7%) on the high end.

It is best to overestimate your needs a little. Yes, you'll be buying and paying for a little more insurance than you need. But if you underestimate, you won't realize your mistake until it's too late.

If a stay-at-home spouse dies, the target is a little harder to figure. Unless there's someone like a grandparent who could move in and take over, the survivor will need to pay to have things done. And that can get expensive. Add up laundry, cleaning, cooking, day care and a hundred other chores and you have an idea of what the at-home spouse's "salary" is that needs to be replaced. Then calculate like you did for employed spouse.

Another way to look at the problem is to have enough insurance to cover your expenses. The calculation is the same. Just use expenses instead of income in your calculation.

Insurance companies will often encourage you to buy enough insurance to pay off your mortgage or other debts. That's nice, but it's not really necessary.

When you consider how much money you'll need, be sure to take inflation into account. Even a modest 3% inflation rate will cut the amount your income will buy in half every 24 years. So if you lose a spouse in your 30s, your dollar will lose half its value before you retire.

Anita should also consider what would happen if both parents die while the children are small. Hopefully they have someone who's agreed to raise their children. If so, the question becomes how much is needed to allow the children's guardians to house the children (bedroom addition? a bigger home?) plus the extra expense of feeding, clothing and schooling the children.

One final thought. Anita will also want to make sure that the insurance policy is set up properly. Choosing the correct owner and beneficiary can have important consequences.

About the author: Gary Foreman has worked as a Certified Financial Planner and currently edits The Dollar Stretcher newsletter and website www.stretcher.com.