If you are wondering how much life insurance you need I have some very good news. First, finding the answer is pretty straight forward as you’ll see. Second, by asking this little question you’ve also found the key to saving a lot of money on life insurance. You see exactly what I mean in just a bit.
The Key
The key to knowing how much life insurance you need is to think about your risks. Understand what your exposure is, how great that exposure is and the timing of those risks. The best way to explain this is by way of example.
Jane and Bill are both 45 years old. They have 3 children. They have a 20 year old daughter Mary, a 14 year old son Max and another 6 year old son Ron. They have been tracking their budget for years and understand that it costs them $75,000 before tax to live right now.
Assuming they have no other savings, the family needs enough life insurance to replace that $75,000 that it costs them to live should the income stop coming in. (That’s the case now but of course that number will change as the kids leave home and start their own lives and other circumstances shift. We’ll talk more about that shortly.)
In this case, Bill is a stay at home dad and Jane brings home the paycheck every month. So in this very simple example, Jane needs enough life insurance to replace that $75,000 the family needs should she die prematurely. That’s how much exposure they have now.
A Rule of Thumb
Now, the question is how much do they have to invest to earn $75,000 each year? (To understand how investments create income you have to think about total return rather than simply the interest the investment generates. It’s a rather complicated subject. Don’t worry if you don’t understand this fully right now. I’ll write more about that at a different time. )
To save time, let’s just assume that your family could withdraw 4% of the amount they invest. That means if you take $75,000 and divide it by 4% you’ll know how much insurance Jane needs to buy. In this case, it works out to be $1,875.000. In other words, if the Jane dies and she has life insurance in the amount of $1,875,000 the family can invest that money and withdraw 4% of it every year ($75,000) and probably never run out of money.
Let’s take this understanding and apply it to your situation right now.
1. Spending
If you want to make sure you have the right amount of life insurance, your first step to determine what you spend on average each month. There are a number of ways to figure this out. The easiest way to do this is to simply track your spending. Just remember that you want to make sure you include EVERYTHING you spend rather than just those things you remember to track. A software package that allows you to download your banking and credit card accounts is a great way to accomplish this.
Once you know what your historical spending looks like, it’s time to do some projections. Think back to Jane and Bill. Their spending is going to change over time. At some point the kids will be independent and their mortgage will be paid off. That means they may not need $75,000 to live on down the road. You need to think about what your future financial needs are going to look like as well. Consider reduced costs but increased inflation in your calculations.
2. Assets and Liabilities
Keep in mind that as your net worth increases, you need less life insurance. That’s because your assets can create income too. Think about it. If you had $1,000,000 invested, you could use that money to generate $40,000 a year using our 4% withdrawal rule. If your family spends $75,000 a year, you already have $40,000 of that covered. That means you only need to replace $35,000 and that means you’ll need a lot less life insurance.
Right now, you may not have much saved up and invested but if you do a mini-financial plan, you can project out how much your savings will be over the coming 10 or 20 years and that’s going to reduce your need for life insurance too. And as your liabilities are paid off, the same principle applies; you’ll need less life insurance.
3. Bring It All Together
At this point, all you have to do is fill out an excel spreadsheet making projections for:
- Your spending
- Your Assets
- Your Liabilities
For each year, divide your annual projected spending by 4%. Then subtract the sum total of your assets less your liabilities. That is how much life insurance you will need.
It won’t be perfect but this will give you a rough idea of what your life insurance needs are going to be over the years ahead. Run through this exercise each year to make sure you’re on track. If your spending, assets or liabilities change dramatically (or fail to perform as projected) your need for life insurance will change too.
By first examining and understanding your risks, you’ll make much better decisions about buying the right life insurance in the right amounts.
