Life Insurance: How much should I have?

Quick disclaimer: The views put forth in this commentary solely reflect my opinion.

You’re born. You live. You die.

Understandably, no one wants to talk about that last part, especially if it is premature. But when it comes to financial planning, protecting your loved ones from this risk is one of the first things that should be covered.

Whenever there is a low probability but high impact event – such as the premature death of a family’s main provider – it is best to transfer this risk to an insurance company. Without life insurance, there is risk of financial ruin for dependents in the family such as children and spouses. The trade-off can be a low-cost insurance premium that shouldn’t impact your family’s standard of living.

What many people fail to realize is that their ability to earn income is their most valuable asset, not their home or their 401K. So, the loss of that income would be a huge detriment to their family.

To explain this, it is helpful to de-humanize it. Let’s say that instead of you being the main provider, you have a “one of a kind” machine in your family’s garage that pumps out $100k per year. It is your most important asset – more important than your home – and there is no way you can pay for an exact replacement. The $100k pays for most of your family’s bills, including the mortgage, the car payments, the kid’s daycare costs, soccer league, and funds the college savings. Unexpectedly, lightning strikes a tree in your yard; it falls on your garage; and takes out your money machine. It is now broken beyond repair. In an instant, $100k per year goes to zero.

What would you do? Did you insure that machine? If so, for how much and for how long?

In most cases, you don’t need to overcomplicate the insurance need analysis. I have seen people account for reduction in future retirement savings, debt reduction, immediate cash needs, etc. While it is fine to do this, I believe in most cases the ‘KISS’ (Keep It Simple Stupid) concept works just as well. 10 years of income replacement seems to be the most popular consensus among financial advisors, although I often see people use 7 to 15 years of income replacement. A quick easy example is if you (the money machine) make $100K per year, then 10 years of income replacement equates to a $1 million insurance need. Your beneficiary, hopefully with the advice of an advisor or trustee, can determine how to best use the proceeds - for example: whether they pay off some debt or use proceeds as income to continue making debt payments. I typically recommend 15 years for younger families just starting out, given the kids will be dependents for a longer time, and especially if they want a college fund. Many people do not realize that what they are given at work, typically 1 to 3X salary, usually is not even close to the right amount!

Okay, so now, what type of insurance should you get? Term life generally has the lowest annual premium and is the most basic: you pay a premium for coverage over a specified time such as 10 or 20 years. Keep in mind, you must pay the premium each year to maintain this type of coverage. Other types, which may or may not be more cost efficient over time, include Whole Life, Universal Life, and some hybrids. These should be discussed with your financial adviser or an accredited person who fully understands how these complicated insurance vehicles work. They should be able to take into account your goals, needs, assets, family, and overall financial situation to see which type or combination best fits you.

Throughout all of this, remember to insure against what can ruin you or your family. For example, would you buy a house and not insure it? No? Would you say that this house is more valuable to your family than your ability to earn for your family? No? Then, getting life insurance makes a lot of sense. And lastly, remember to “KISS” and think about how many years your family might need your income.

One last quick note is for the few that feel they have the abundant assets to self-insure. If you have these abundant assets, let’s say a net worth of over $10Million, then you may want to consider using an insurance policy within an Irrevocable trust as an estate preservation strategy. Estate planning is a completely different beast and much more complex. For this reason, I want to stress that this type of planning should be done with the help of a legal professional, tax professional, and financial professional.

The information provided is general and intended to inform and educate. It is not intended as an offering of any specific products or services, nor to be construed as specific investment, legal or tax advice. Past performance is not indicative of future results. Individual situations can vary, as such; this information should only be relied upon along with an individual assessment in light of your own specific situation. A thorough analysis would consider a variety of factors that are beyond the scope of this commentary and should be applied to your unique situation along with the help of a professional.