There are a bunch of different ways to determine how much life insurance you need, from a simple “ten times your salary” to complex Monte Carlo simulations. Somewhere in between is the “capital needs analysis”, which is often used by insurance brokers and financial planners. This is what most online life insurance calculators use (examples here, here, and here), although I like the idea of doing it by hand to play with the numbers. I have a brochure from my State Farm agent with some stats, and also found another good example in this worksheet.
What is your goal?
Here’s the fun part. You get to imagine you’re dead. Will the remaining partner stay at home with the kids? Work and pay for daycare? Some people basically want to replace everything – their future income and also leave an inheritance or other lump-sum. Others want to make sure their dependents would be able to live as close to the “same life” as possible. This means staying in the same house, working (or not working) at the same jobs, driving the same cars, the same lifestyle. Then there is the “adapted life” approach, where maybe they would downsize somewhat, but have all the critical areas covered.
How much monthly income will your survivors need?
It’s usually easier to think of this monthly, and then multiply by 12. Include housing, transportation, education, childcare, insurance, entertainment, and perhaps also regular retirement savings. The average cost of daycare for a 4-year-old is around $8,000 per year. Now subtract any sources of income. The survivor’s salary, existing passive or investment income, rental income, Social Security benefits, etc.
Then, you have to decide what amount of money can create this income. Lots of guessing on your rate of return and length of withdrawal period is involved here. If you are young, you could buy an immediate annuity which will pay out about 4% inflation-adjusted a year (a certain % will be taxable). This is the same as multiplying by 25. So to create an annual income of $40,000 per year, you’d need a lump sum $1,000,000. As you get older, the payoff gets better. A more conventional approach seems to multiply by about 15.
Add in lump sum expenses
You’ll probably want to take care of debts like student loans, credit cards, funeral costs, and medical bills. A recent survey put the average funeral cost at over $6,000. If you haven’t already accounted for it above in housing, you may want to pay off the mortgage on your home or set aside money for retirement. Finally, you may want to consider the education costs of your children. The average cost for tuition + room/board for an in-state college is now nearly $14,000 per year.
Add these two big numbers up, and you have you future capital needs. You can then subtract out the insurance you have through work if you like. Finally, you should subtract your current assets, taking into account their liquidation restrictions. The difference provides an estimate of how much life insurance to shop for.
This all sounds simple, but in going through it myself there are so many variables. For starters, most couples will probably have different insurance needs for each person. Do I really want to pay off the entire house, or just allot for the mortgage payment? How many kids am I supposed to plan for? I end up with a number anywhere between $500,000 to more than $1M depending on different assumptions. (I’m open to advice here.) The good thing is that I am hoping that each $500k of coverage will only be about $30/month. I also may end up buying multiple life insurance policies as life goes on and stack them on top of each other.
If you buy a 30-year term policy with $500,000 of coverage now, at 3% annual inflation that you benefit will only be worth half as much after 23 years. But I don’t really worry about that, because for every year that I keep living, I should be saving enough that I don’t need as much coverage. And after the end of my term, we should have enough assets so as to not need any life insurance at all.