How Much
Life Insurance Do You Need?
You might be asking yourself this question:
"How much life
insurance do I need?"
Some financial
advisors will tell you to multiply your
annual income
by seven. Others will tell you to buy
only enough life insurance to replace
the income
you are expected to make between now and
retirement.
Some might recommend you buy only enough
life insurance to cover
your present debts.
While you probably can do all of those
calculations in a minute, they won't give
you the right answer. Simply put, calculating
your life insurance needs takes homework.
It requires you to do an inventory
of all of your finances,
and to think long and hard about how your
beneficiaries would maintain their lifestyles
without you. You also must consider inflation
and, if you have children,
future college education
costs.
What not to do
What's the wrong way to calculate how
much life insurance you need? Here are
some common but misguided methods.
1. Multiply your annual salary by seven
or eight: While it’s a simple formula,
it fails to take into account your individual
needs and obligations. Life insurance
experts say there’s a good chance
you’ll buy too little or too much
coverage, simply by using a formula such
as this.
2. Calculate your "human life value:"
This method gives you the income you will
earn from your present age until your
retirement age, assuming a rate of interest
that represents salary increases throughout
that period. The problem is it does not
take into account what your beneficiary's
specific needs will be. You also end up
with a figure that requires you to buy
a huge amount of life insurance, possibly
more than you may need. "There's
all sorts of landmines in this,"
says Michael Snowdon, an instructor at
the College of Financial Planning in Denver.
"When you calculate this way, you're
working with broad brush strokes."
3. Cover your debts. This involves buying
only enough life insurance to cover debts
such as your mortgage, student loan bills,
or outstanding car notes. This method
does not consider any future debts or
needs, such as childcare or college education
costs.
A classic formula
Many experts say the best way to pinpoint
a smart life insurance figure is through
a needs analysis, which can be broken
down into a simple formula: Short-term
needs + long-term needs - resources =
how much life insurance you need. Snowdon
says this method is "probably the
most accurate approach in what is an inaccurate
and imprecise science."
Experts advise you do an analysis at least
once every three years, or whenever you
have had a major life change. For example,
if you have a new baby, you have to recalculate
college education needs and child-care
costs. If you own a home, a mortgage is
likely your biggest financial burden.
Because your mortgage balance decreases
with each payment, it's important to include
those revised figures in your calculations.
Five steps to a needs analysis
Step 1
Add up all of your short-term needs. These
can be placed into three categories: final
expenses, outstanding debts and emergency
expenses. Among final expenses are medical,
hospital, and funeral expenses, attorney
or executor fees, probate court costs
(if you do not have a will), and any outstanding
taxes that would need to be paid if you
died. Among outstanding debts are credit
card balances, auto loans, college loans,
and all other outstanding bills. Emergency
expenses should include a cash reserve
for medical emergencies and repairs to
your home or car.
Calculating final and emergency expenses
can be complicated, because you don't
have a crystal ball that tells you how
much your medical or hospital expenses
will be, or if you even will have any.
Step 2
Next, add up your long-term debts, which
include your mortgage and college tuition.
Calculating an education fund is tricky
because you have no idea where your children
will be going to college. Perhaps the
best method is to use the present average
college cost in the United States and
the number of years away your children
are from entering college. The average
college costs for the 2002-2003 school
year were $4,081 annually for a public,
four-year institution, and $18,273 annually
for a private, four-year institution,
according to The College Board.
The U.S. Department of Education reports
college costs traditionally have risen
at about 5 percent annually, so you need
to figure out what the cost will be when
your child goes to college. (To calculate
what costs will be in the future, see
the last section: “A must-know:
the equation for the future value of money.”
Also be sure to calculate what the entire
education will cost while taking into
account the increased costs each year.)
Step 3
Next, calculate family maintenance expenses.
These include such necessities as childcare,
food, clothing, utility bills, entertainment,
travel, and transportation. Calculate
this figure based on a year's worth of
expenses, then multiply that times the
number of years you want to provide this
income.
Once you've done that, add your short
and long-term debts and your family maintenance
expenses.
Step 4
Now that you've tallied all of your income
needs, figure out what resources you have
to meet them. To do this, add all available
savings, stocks, bonds, mutual funds,
existing life insurance (such as group
life through your employer), and Social
Security. You and your spouse can find
out how much you'll get through the Social
Security Administration (SSA) by visiting
the SSA’s website, where you can
get an estimate of how much you should
have in Social Security benefits. Also
add your present salary, and assume 5
percent compounded interest each year
if you expect salary increases over time.
It's important to count only liquid assets
(those that could be quickly converted
to cash) among your resources. You shouldn't
count items such as your home or automobile,
because selling them for cash when you're
gone would mean changing your family's
lifestyle.
Step 5
Subtract your resources from your total
expenses. The figure you get should represent
the amount of life insurance you should
buy.
Don't be daunted
Snowdon says the final figure that shows
how much life insurance a person needs
can be quite alarming. If you end up with
an astronomical figure that requires a
premium that is too high, he recommends
you go through the analysis again and
select areas for which you think you can
allocate less money.
"Many people will look at the final
figure and say, 'I can't do that,'"
Snowdon says. "You have to look at
it, figure out which is the most crucial,
start making adjustments, and go from
there."
A must-know: the equation for the future
value of money
Calculating your life insurance needs
will require two equations you may have
picked up in Finance 101: the future and
present value of money.
The future value of money equation tells
you how much your money will be worth
in a given number of years while earning
a given rate of interest. This equation
is essential if you are calculating how
much money you'll need in the future because
of inflation, or what your death benefit
will be if you choose to invest the money
at a given interest rate.
The present value of money equation tells
you what your money is worth before it
has been invested for a given number of
years at a given rate of interest. This
is important if you have an amount of
money you need in the future, and you
need to know how much life insurance coverage
you should buy now.
If this sounds complex to you, don't fret.
As long as you have a calculator (preferably
a financial calculator, which is used
by accountants and finance professionals),
these equations are no sweat.
Here's how the future value of money equation
works: Say that average college education
costs are $20,000 annually for a private
four-year institution, and you want to
figure out how much it will cost in four
years if college costs keep going up 5
percent per year. You would multiply 20,000
by 1.05 (1 represents the present cost,
and .05 is 5 percent inflation) four times
(or 1.05 to the fourth power).
So your equation would be this:
20,000 x (1.05)4
or
20,000 x (1.05)(1.05)(1.05)(1.05)
The answer is $24,310.13.
Courtesy of Insure.com
