How Much Life Insurance Do I Need?

“Dream as if you'll live forever, live as if you'll die today." 
― James Dean

“A policy of life insurance is the cheapest and safest mode of making a certain provision for one's family."
― Benjamin Franklin

“Keep love in your heart. A life without it is like a sunless garden when all the flowers are dead." 
― Oscar Wilde

If you have people who depend on you and your income, you’ve hopefully thought about signing up for some life insurance, but how will you decide how much life insurance you need?

The Life Insurance Need vs. A Culture Of Sales

I began my own financial planning career in a firm that focused on selling life insurance. Eventually I gave up my insurance license and commissions to cast my lot with those in favor of fee-only financial planning, but before that I spent a lot of time wrestling with how to best determine how much life insurance a person needs. It was a struggle because unfortunately in the world of life insurance sales, the simple answer to “how much?” is often, “as much as your client can afford.”

Ironically, my distaste for the culture of life insurance sales and commissions is equally matched by my belief in the importance of proper coverage. Fundamentally, life insurance solves a need. It’s a tool in a toolbox. It protects those who rely on us financially from suddenly experiencing life-altering financial disaster. And so I ask you, if you could provide for your family for the rest of their lives for $100/month, would you? I know it sounds drastic, but if you discovered today that you had 3 weeks to live, would you kick yourself for not having coverage? If I weren’t insured, I know would.

If proper life insurance is important but the life insurance system is designed to sell as much as possible to anyone possible, how do you determine how much life insurance will actually accomplish the purpose of providing for your family in case of your death?

The good news is that there are financial planners who have a fiduciary commitment to work in your best interest and who will help you with this. The second piece of good news is that a little bit of knowledge goes a long way. Today we’ll explore a few methods for determining your life insurance needs.

Depending on how your need is calculated, you’ll come up with significantly different numbers. Let’s discuss the Financial Needs Analysis and the Human Life Value approaches. One begins with our current and projected expenses; the other relies on our anticipated lifetime income for the calculations.

Financial Needs Analysis

Using Financial Needs Analysis, we evaluate all our current financial commitments that would continue after our death along with any one-time needs. We tally up educational funding, mortgage, additional debt, dependent care needs (kids), and lifetime income needs for non-working spouses, projecting forward current expenses with an allowance for inflation. Additionally, the insurance should cover funeral and final expenses. We begin with the financial needs of those who rely on us and work backward from there. The potential pitfalls in this approach lie in our inability to forecast unknown costs. We’re not sure if our kids will need us to cover a four-year private university and graduate school or if they’ll get a full ride through college or have no desire for further education. 

Human Life Value Analysis

An alternative to the Financial Needs Analysis is Human Life Value calculation. Rather than beginning with current needs, the starting point would be the insured’s lifetime anticipated earnings. This method will likely produce a larger expected need than the needs analysis, since it accounts for total income, rather than just what will be spent on current expenses. Expanding lifestyles and our future savings may or may not be factored in. The weakness of this method is that it tends to produce what at first glance can feel like eye-popping numbers, and a reticence to carry the cost of the prescribed insurance. A 35-year-old software engineer, making $150,000 now, with an annual salary increase of 4% will make $8.4 million over the course of their lifetime. If 40% is eliminated by taxes, the engineer is still left with a human life value of roughly $5 million. Additionally, the Human Life Value method may or may not line up with our actual needs. A software engineer with a mortgage and children planning to live in San Francisco indefinitely has very different insurance needs than one who plans on moving back to Ohio to start a family in the near future.

So what about Whole Life? (Term vs. Permanent)

Up to this point, I’ve only discussed how much insurance to consider, not whether to purchase term or permanent insurance.

Term insurance covers a fixed time period, ideally with fixed premiums and a fixed death benefit. That is, if I die anytime in the next 30 years my insurance beneficiary will receive X dollars upon my death. After the term expires, the insurance company retains my payments, and I happily have retained my life.

Permanent insurance is a very different tool from term insurance. Permanent insurance’s primary value lies in the tax-free death benefit which the beneficiary is guaranteed to receive for as long as the policyholder paid the premiums. The secondary significant value lies in the ability of the policy owner to borrow against the policy cash value in retirement for tax-free income. Properly designed policies function somewhat like a Roth account invested in bond funds. It’s a safe way to grow money slowly and tax-free. It can also function as a forced savings mechanism as you continue to pay policy premiums.

In general, this tool functions best for those who already annually max out their retirement contributions and have additional funds they would like to save, or for those whose gross estate will grow to over the current $11.2 million dollar estate tax deduction ($22.4 for married couples) and would like to provide liquidity to pay taxes for the remainder of their estate. 

Which of these tools works best for you and how much each will cost you depends on a variety of factors, including your age and health history. It’s probably worth considering speaking with a fee-only financial planner alongside an insurance broker who can walk you through your options.