No emotion is necessary when you are calculating how much life insurance you really need. Just math. Let’s try to add it up here.
Following the September 11th terrorist attacks and the creation of numerous victims’ compensation funds, numerous scholars and financial economists roundly debated the economic value of a human life. Varying complex equations aside, many experts agreed on an average factor of twenty times (20x) an individual’s annual income. Some people reading may be thinking some version of the following: “whoa, that would be a lot of life insurance! My employer pays one times (1x) my salary and my wife and I both took out a $500,000 policy when we bought our house to cover the mortgage payments before she became pregnant with our first child. Do I really need that much more?” Well, let’s talk about it. First, I will assign some names and numbers to this scenario before we step back and look at how they came up with this average number.
Jim and his wife Ann are both 37 years old and have two (2) younger children. In this example let’s consider Jim’s W2 income of $72,000. We will also assume that Ann’s income is exactly the same for tax purposes. Most people hope and plan that their income will go up as they get older so we will also assume an income inflation rate of 2.5% annually for this example. By age 65, Jim will have earned $2,869,905 in income and, for the sake of simple math, we will assume a twenty-five percent (25%) average effective rate of taxes to mean about $2,152,428 in after-tax-earnings. But we need to also look at lost savings. Since we already counted Jim’s income and taxed it cumulatively, we will assume $8,000/year of that went into a market account with an after-tax equivalent of $3,000 employer match and a 5.5% annual growth rate net fees. This would be a growth over basis of $506,802 lost. If we count childcare due to the loss of a parent of $5,000 a year for 10 years that’s an additional loss of capital potential of $98,797 using the same growth rate.
Add this all up and Jim’s total economic value and capital potential is $2,758,027. So, one might say Jim’s total insurable earnings would be close to thirty-seven times (37x) Jim’s current annual income. This is an example of how typically insurance companies will write between 35-40 times an individual’s annual earnings in their thirties. As age goes up this multiple goes down because the individual’s future earnings and capital potential is less.
“OK, OK,” you’re saying. “I appreciate all the math and this example but how much insurance do I need now that I know about how much the insurance company thinks I’m worth?”
OK, let’s look at it a different way. The Monte Carlo safe withdrawal rate on market-based investments for a thirty (30) year period with a 90% chance of not running out of money is currently 2.8% down from a more historical average of 3.5-4.5% due to the trending low interest rate environment. Basically, this means higher rates of returns have to rely on riskier stocks rather than safer interest rate driven investments. The safe withdrawal rate per $/million invested is just $28,000 meaning a death benefit of $2,270,571 would be necessary to pull $63,576 with a high degree of safety each year for the next thirty (30) years. This is about what Jim might net after taxes with after tax equivalent savings added back in for retirement planning. Adjusted for inflation that amount would be much higher.
This is only one scenario simplified for clarity’s sake and assumes a married couple with younger kids. There are obviously many other factors and variables. Some of which reduce the need for insurance, but many would justify more coverage. I’ve heard the comment “I’m over insured” many times and I’m the first to point out that an insurance company is not in the business of over insuring someone’s life any more than they are in the business of over insuring a house against a fire, flood, or hurricane. Many of us in the Port City experienced that firsthand with Hurricane Florence. There is always a loss well over and above the insurance check you may or may not have received in the mail. Just like you wouldn’t intentionally underinsure your house, you don’t want to underinsure your life. Ultimately, the main factors that determine how much insurance an individual would want to carry depends on their age, family status, future income potential, and savings and retirement goals.
Everyone’s situation is certainly different, but it is for that exact reason that you can and should be seeking out tailored advice for yourself when it comes to life insurance.
The information contained in this article is general and is provided for educational purposes only. It is not intended to provide legal or tax advice. You should not act on this information without consulting your own legal counsel and/or other knowledgeable advisors.
Beck Smith is an experienced consultant with GriffinEstep Benefit Group who routinely advises business owners on income and asset protection as well as other advanced insurance planning needs. Established in 1998, GriffinEstep is a leading independent, full-service insurance brokerage company with a team of consultants dedicated to clients, not insurance companies. GriffinEstep provides a unique combination of national expertise and local presence along with the knowledge, insight, and technology necessary to customize the individual insurance needs of its valued clients.
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