LIFE INSURANCE
How Much Do I Need?
Once you decide that life insurance is a good idea for you, you need to determine how much you need. Perhaps you, like most people, want enough life insurance to make sure your family can continue to live its current lifestyle in the event you die. If the primary purpose of life insurance is to provide annual income for your loved ones, the insurance amount will, ideally, be enough to replace what you would have earned until the age at which you would have retired.
When you purchase insurance for your home or car, you need to know the replacement cost. In much the same way, you need to consider the replacement cost of the economic contribution you bring to your loved ones. Your contribution is, after all, a vital asset for your family.
Your goal should be to develop a life insurance plan (through one or more policies) that, in the event of your death, compensates for the loss of your economic contribution. There are several ways to determine the dollar amount of life insurance you need to accomplish this goal.
One method often used is to calculate Replacement Income Need—a comprehensive approach to determining the financial contribution you can expect to make to your family from now until you would retire.
To estimate your replacement income need, multiply your annual income by the number of years until retirement. Add in the replacement cost of benefits you receive, such as health insurance, and the replacement cost of services you perform as a family member (e.g., cooking, childcare, home maintenance). Subtract out an estimate of your personal consumption—annual spending on personal needs multiplied by number of years until retirement—to arrive at a figure. This number is an estimate of the dollar amount of life insurance needed.
Another approach that has been used in the financial services industry for many years is called the Survivor Needs Analysis. This approach is based on replacing an amount of income needed for your surviving spouse and children. Your survivors’ needs are then compared to their assets, existing life insurance and income sources to determine any additional life insurance requirements. This approach incorporates a vast array of financial data, relying on a number of assumptions.
However, if a straightforward, basic approach to determining your family’s life insurance needs appeals to you, then you might want to consider the Simplified Needs Analysis Calculator below. This can help you to determine how much insurance is right for you. Just fill in the blanks to estimate your family’s needs.
Five times your personal yearly income =
____________
(1)
Expenses above and beyond your daily living costs for you and your dependents amount to =
(e.g. tuition, care for a disabled child or parent)
____________
(2)
Your emergency fund amounts to =
(3 to 6 months of living expenses)
____________
(3)
Estimated amount for your funeral expenses =
(U.S. average is $5,000 to $10,000)
+ ____________
(4)
Total estimate of your family's financial needs =
(add lines 1 through 4)
= ____________
(5)
Your total liquid assets =
(e.g., savings accounts, CDs, money market funds, existing life insurance)
- ____________
(6)
Subtract line 6 from line 5 and enter the difference here:
= ____________
(7)
The net result (Line 7) is an estimate of the shortfall your family would face upon your death. Remember, these are just rules of thumb. For a complete analysis of your needs, consult a professional.
Remember, the specific amount of life insurance you need to protect your loved ones depends on many factors—assumed rate of return on investment capital, future interest rates, inflation assumptions, future earnings, and future expenses—and an insurance professional or financial advisor can help you determine an accurate figure and choose appropriate coverage.