By Adam K. Wright, CFA®, CFP®
Insurance is a key component to financial plans—and especially life insurance. Ultimately, life insurance’s highest and best use is to replace the economic loss of income due to premature death.
Life insurance is risk transfer. You make a deal with the insurance company along the lines of: should I die unexpectedly, you’ll pay my family a lump-sum benefit. For that benefit, I’ll pay you a monthly cost.
Life insurance is vital for those young families that are early in their financial accumulation. After a while, once financial independence is reached, the need for life insurance may end. That’s because if something happens, you have plenty in the bank or in investments to support all your survivors. Financial independence means you can self-insure.
Reviewing life insurance needs as you approach retirement is an important part of the retirement planning process. It’s also an important part of an ongoing financial planning process.
Now let’s discuss what to consider and the process we use to determine the right life insurance amount for you.
First, consider the purpose of your life insurance coverage.
Like all aspects of a financial plan, it is best to attach financial solutions to goals. So, before you run out and buy a life insurance policy, ask yourself: In the event of my untimely passing…
- Will my survivors need financial support?
- Will there be outstanding debts and obligations that need to be paid?
- Will there be costs for my estate such as taxes or funeral expenses?
- Do I have wealth transfer goals?
- Am I worried about future insurability?
If you’ve answered yes to any of these questions, you should consider purchasing life insurance, reviewing your current protection needs, or adding to existing coverages.
This is especially true if you have decades of earnings ahead of you and dependents reliant on you. At the same time, if you’re approaching or planning for retirement, ask these same questions. Life insurance can be an important tool during the first few years of retirement too.
Then determine a reasonable coverage amount.
There are a variety of ways to arrive at a coverage amount, any of which will help you figure out the right amount of life insurance to buy. Here are three to help you triangulate your needs.
Multiple of income
Possibly the most straightforward, this technique suggests you purchase life insurance based on some multiple of your income. For example, research and practitioners tend to suggest financial independence is reached when your retirement and investment assets are 25X your annual lifestyle costs. So, say you have a young family and you live on $100,000 per year, consider a $2,500,000 coverage amount as a starting point.
Human Life Value
Okay, this one requires some math. The human life value approach suggests you buy life insurance based on your human life value, which is the present value of your estimated future earnings throughout your life expectancy. For example, if you make $100,000 per year, have 20 years to retirement, a discount rate of 5.0% and a 22% tax rate, your human life value is estimated at $975,000 which may be used as your coverage amount.
Financial Needs Analysis
Another option to calculate life insurance needs is based on determining a lump sum for ongoing income needs adjusted for debts and other assets. For example, your family lives off of $100,000 per year, but part of that is a mortgage of $250,000 that costs $12,000 per year. And you have $150,000 saved in your investment accounts. That makes your core lifestyle costs $88,000 and net debt of $100,000. If we use the same 25X multiple as before PLUS debt payoff, consider coverage of $2,300,000.
Now consider your policy options.
Once you’ve determined how much you need, consider how long you want your protection to last. For many with a young family, a 20- or 30-year term policy likely makes sense. However, needs vary and some families may want coverage to last their entire lives and would prefer a permanent policy.
A starting point, and a cost-effective solution for many, is to see if your employer offers a group life insurance benefit. If the coverage available doesn’t meet your needs, you can purchase additional coverage directly from an insurance company.
When purchasing directly from an insurance company, review their rating, financial strength, and history. If you’ve been paying a premium for decades, you want to make sure the insurance company is around in the future to pay your benefit should disaster strike!
Last, compare your current coverage to your needed coverage.
After figuring your goals and life insurance needs, you may see a gap. You could be either over- or underinsured. If underinsured, let’s talk. We’ll review your financial plan and see what type of policy is in your best interest. If you think you’re over-insured, let’s still talk. Before canceling coverage, it will be important to review your goals, since it can be very hard to re-acquire coverage in the future if your circumstances change.
How do you get “cheap” life insurance?
The biggest factors affecting life insurance are age and health. For many, it is best to get insured when you are young and healthy. This is before you have to go to the doctors for surgeries, procedures, and many other factors that would give you an increased rate.
Typically, when you are talking about cheap life insurance, most people are referring to term insurance. It is low-cost and lasts for a set period of time (10, 20, 30 years or more). If you don’t pass away during the term, you don’t get anything back for it—other than peace of mind. Also, about 2-3% of term policies actually pay out since most people outlive them or they become too expensive to keep and surrender them.
If you are young and healthy, you want to get your life insurance with a mutual company (not publicly traded) because they will hand out the best rates for healthy people.
Our financial planning process includes a periodic insurance review.
Life changes, sometimes by a lot, and quickly. That means insurance needs change as well. In an effort to keep financial and retirement plans up to date, we review personal insurance coverages every few years. For most that means taking a look at not just life insurance but also disability and long-term care coverages.
Wondering how your life insurance fits in with your financial goals? We at Wright Associates can help. Schedule a risk and insurance review today and make sure you’re protecting what’s important.
Adam Wright is a CERTIFIED FINANCIAL PLANNER™ at Wright Associates, helping clients plan and prepare their investments to retire on their terms. If you’re serious about planning for your retirement and investing for your future, his annual process will help you make the right money choices today. Therefore, Adam and his team will proactively manage your accounts while communicating the progress of your financial plans. He believes the retirement advice you receive should be intentional and actionable.
Adam has a Bachelor of Science in Supply Chain and Information Systems from The Pennsylvania State University and a Master of Business Administration from University of Pittsburgh, Katz Graduate School of Business. He lives in Upper St. Clair with his wife and two children. When he’s not working, Adam enjoys the outdoors (fly fishing), reading, and taking long runs while listening to a favorite podcast. He’s also currently encouraging himself to take up golf. To learn more about Adam, connect with him on LinkedIn.