Determining the magnitude of the possible losses resulting from a premature death can be complicated. Two methods are commonly used: a multiple-of-earnings approach and a needs-based approach. The needs-based approach is more accurate and reflects the changes in family status, income, assets, and age that will occur over your life cycle.
The Multiple-of-Earnings Approach: Easy But
Flawed The multiple-of-earnings approach estimates the amount of life insurance needed by multiplying your income by some number, such as 5, 7, or 10. Thus, someone with an annual income of $40,000 would need $200,000 to $400,000 in life insurance. Another multiple-of-earnings approach is to use the interest factors from Appendix Table A.4 for an expected investment rate of return and a given number of years of need. The logic here is that at death, the survivor could invest the funds received from the life insurance policy on the person who has died to provide a flow of income for the number of years desired. For example, a father who wishes to provide his family with income of $40,000 for 20 years at a real rate of return of 4 percent (after inflation and taxes) would need to have about $550,000 ($40,000 x 13.59) of life insurance protection on his life. The shortcoming of the multiple-of-earnings approach can be seen in the wide range of dollar amounts that result. This approach addresses only one of the factors affecting life insurance needs—income-replacement—and does not take into consideration such factors as age, family situation, and other assets that could cover the lost income.
The Needs-Based Approach: A Better Method The needs-based approach to estimating life insurance needs considers all of the factors that might potentially affect the level of need. It improves upon the calculations of the multiple-of-earnings approach by including a more accurate assessment of incomereplacement needs and incorporates factors that add to and reduce the level of need. The Decision-Making Worksheet, “The Needs-Based Approach to Life Insurance” (page 326), illustrates calculations made via the needs-based approach. You would be wise to calculate your current needs for life insurance and then to revisit those calculations every three years and when changes occur in your family situation or health status.
Calculating Life Insurance Needs for a Couple with Small Children
Consider the example of Zoel Raymond, a 35-year-old factory foreman from Holyoke, Massachusetts, who has a spouse (age 30) and three sons (ages 8, 7, and 3 years). Zoel earns $48,000 annually and desires to replace his income for 30 years, at which time his spouse would no longer need to support their children financially. The “Example” column of the Decision-Making Worksheet expands on the situation faced by Zoel.
The Multiple-of-Earnings Approach: Easy But
Flawed The multiple-of-earnings approach estimates the amount of life insurance needed by multiplying your income by some number, such as 5, 7, or 10. Thus, someone with an annual income of $40,000 would need $200,000 to $400,000 in life insurance. Another multiple-of-earnings approach is to use the interest factors from Appendix Table A.4 for an expected investment rate of return and a given number of years of need. The logic here is that at death, the survivor could invest the funds received from the life insurance policy on the person who has died to provide a flow of income for the number of years desired. For example, a father who wishes to provide his family with income of $40,000 for 20 years at a real rate of return of 4 percent (after inflation and taxes) would need to have about $550,000 ($40,000 x 13.59) of life insurance protection on his life. The shortcoming of the multiple-of-earnings approach can be seen in the wide range of dollar amounts that result. This approach addresses only one of the factors affecting life insurance needs—income-replacement—and does not take into consideration such factors as age, family situation, and other assets that could cover the lost income.
The Needs-Based Approach: A Better Method The needs-based approach to estimating life insurance needs considers all of the factors that might potentially affect the level of need. It improves upon the calculations of the multiple-of-earnings approach by including a more accurate assessment of incomereplacement needs and incorporates factors that add to and reduce the level of need. The Decision-Making Worksheet, “The Needs-Based Approach to Life Insurance” (page 326), illustrates calculations made via the needs-based approach. You would be wise to calculate your current needs for life insurance and then to revisit those calculations every three years and when changes occur in your family situation or health status.
Calculating Life Insurance Needs for a Couple with Small Children
Consider the example of Zoel Raymond, a 35-year-old factory foreman from Holyoke, Massachusetts, who has a spouse (age 30) and three sons (ages 8, 7, and 3 years). Zoel earns $48,000 annually and desires to replace his income for 30 years, at which time his spouse would no longer need to support their children financially. The “Example” column of the Decision-Making Worksheet expands on the situation faced by Zoel.
- Final-expense needs. Zoel estimates his final expenses for funeral, burial, and other expenses at $10,000.
- Income-replacement needs. Zoel’s income of $48,000 is multiplied by 0.75 and the interest factor of 17.292. This factor was used because Zoel decided that it would be best to replace his lost income for 30 years or until Mary, his wife, reached age 60 and passed through the Social Security blackout period. Zoel and Mary are moderate-risk investors and believe that she could earn a 4 percent after-tax, after-inflation rate of return on life insurance proceeds. Income-replacement needs based on these conditions amount to $622,512.
- Readjustment-period needs. Mary is a columnist for a local newspaper, earning an annual income of $38,000. Allocating $19,000 for readjustment-period needs would allow her to take a six-month leave of absence from her job or meet other readjustment needs.
- Debt-repayment needs. Zoel and Mary owe $10,000 on various credit cards and an auto loan. They also owe about $128,000 on their home mortgage. Mary would like to pay off all debts except the mortgage debt if Zoel dies. The mortgage debt would be affordable if Zoel’s income was adequately replaced.
- College-expense needs. Zoel estimates that it would currently cost $25,000 for each of his sons to attend the local campus of a public university. If he dies, $25,000 of the life insurance proceeds could be invested for each son. If invested appropriately, the funds would grow at a rate sufficient to keep up with increasing costs of a college education.
- Other special needs. Zoel and Mary do not have any unusual needs related to life insurance planning, so they entered zero for this factor.
- Subtotal. The Raymonds total items 1 through 6 on the worksheet and determine that the family’s financial needs arising out of Zoel’s death would amount to $736,512. Although this sum seems large to them, they have access to two resources that can reduce this figure, as indicated in items 8 and 9.
- Government benefits. Zoel estimates that his family would qualify for monthly Social Security survivor’s benefits of $2725.* These benefits would be paid for 15 years, until his youngest son turns 18. The present value of this stream of benefits is $363,558 (from Appendix Table A.4), assuming a 4 percent return for 15 years.
- Current insurance and assets. Zoel has a $50,000 life insurance policy purchased five years ago. His employer also pays for a group policy equal to his $48,000 gross annual income. Zoel’s major assets include his home and his retirement plan. Because he does not want Mary to have to liquidate these assets if hedies, he includes only the $98,000 insurance coverage in item 9.
- Life insurance needed. After subtracting worksheet items 8 and 9 from the subtotal, Zoel estimates that he needs an additional $274,954 in life insurance. This amount may seem like a large sum of insurance, but Zoel can meet this need through term life insurance for as little as $30 per month.
Because Mary earns an income that is about 80 percent of Zoel’s, her life insurance needs may be about 20 percent lower. To determine the specific amount, the couple must complete a worksheet for her as well. Next, the Raymonds will need to decide what type of life insurance is best and from whom to buy the additional life insurance needed.
Calculating Life Insurance Needs for a Young Professional
Irene Leech of Rancho Cucamonga, California, recently graduated with a degree in tourism management and has accepted a position paying $43,000 per year. Irene is single and lives with her sister. She owes $14,500 on a car loan and $21,800 in education loans. She has about $7000 in the bank. Among her employee benefits is an employer-paid term insurance policy equal to her annual salary. Irene has been approached by a life insurance agent who used the multiple-of-earnings approach to suggest that she needs $215,000 in life insurance, or about five times her income. Does she? If you apply the needs-based approach to Irene’s situation,you will see the following:
- Irene estimates her burial costs at $8000, which she entered for item 1. Because Irene has no dependents, she needs no insurance for income-replacement needs, readjustment-period needs, college-expense needs, or other special needs.
- Items 2, 3, 5, and 6 in the needs-based approach worksheet on page 326 are zero because Irene has no dependents.
- Irene’s survivors will not qualify for any government benefits, so item 8 will also be zero.
- Irene would like to see her $14,500 automobile loan and $21,800 education loans repaid in the event of her death. She feels better knowing that her younger sister could inherit her car free and clear. She entered $36,300 for item 4.
- Irene has combined life insurance and assets of $50,000, so she entered that amount for item 8.
The resulting calculations show that Irene needs no additional life insurance ($8000 $36,300 $50,000 $5,700). The agent suggested that Irene buy now while she is young and rates are low. This, too, is not a smart approach. The lesson here is that you should not buy life insurance simply to lock in low rates. That would be like buying car insurance before you own a car. Unless you have a personal or family-based medical history that might interfere with the purchase of life insurance when needed later, you, like Irene, can wait until family circumstances change to recalculate the need.
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