Suppose the unthinkable happens and you suddenly pass away – would your family have adequate financial protection? You might find a need for more life insurance after confronting this question head on. Different products exist, but in this post I’m focusing only on term life insurance. Term policies serve as valuable financial tools to protect when you have outstanding liabilities and expected future expenses over a well-defined future timeline.
For instance, let’s consider the Cartier family. They are a couple in their late 40s with two teenage children, living in a home they purchased 15 years ago. Their key financial details include:
- 15 years left until retirement
- One spouse works part time earning $50,0000 per year, the other earns $250,000 annually
- 10 years left on their mortgage, with a balance of $700,000 remaining
- Upcoming annual university expenses of $20,000 per child, for three years
- They have positive monthly cash flow and are able to save
- Saving at their current rate, they will have a fully funded retirement
- They each have $100,000 in employer sponsored life insurance
Their concern is what their situation would be if one were to pass away before the mortgage is paid off and the kids graduate from university.
When addressing clients like the Cartier’s, we take a Goldilocks approach between the “Bare Minimum” and “Deluxe” methods Peter previously talked about. Let us start with a serving of (perfectly tasty) cold porridge.
Bare minimum – slightly too cold
The starting point for planning with our clients is to have enough insurance to cover the remaining mortgage balance, all university expenses, and two years of salary, per person. Coverage in this amount means the surviving spouse has a couple of years to reorient after tragedy, without carrying debt, and knows the children’s education fund is secured. Frankly, this is a good place to start if you don’t already have coverage and you don’t want to be oversold insurance.
This method has an appealing feature: it requires little calculation. To calculate what you need, add the debts and future education spending, add 2 times salary, and reduce this amount by existing coverage. For the higher earner, this would mean $1,120,000 more in term life coverage for 15 years ($700,000 + $120,000 + $500,000 – $100,000).
There is a significant drawback to this method: it requires the surviving spouse to earn more (after the initial 2 years) to afford the same lifestyle. In cases where the income gap is perilously large, such as for the Cartiers, the surviving spouse might find it impossible to earn such a combined income. Enter a deluxe batch of porridge, hot off the burner, to solve our problem!
Deluxe method – perhaps too hot
The goal of purchasing life insurance this way is to replace all future after-tax income until retirement. The outcome of this implies that the surviving spouse can continue to earn the same amount without any change in lifestyle. The Cartiers can rest assured knowing their retirement goals would be intact since they are saving and living within their means.
Note that the calculation for this method isn’t taking the yearly net income and multiplying by the number of years until retirement. Since we assume any death benefit could be invested and earn income, we must account for income generated from the lump sum payment. As Peter mentioned in this video, without a net present value calculation, the exact amount required is not immediately clear.
Aside from being a complex calculation, it doesn’t answer questions like when to pay off debts or save, or if this coverage is suitable if the surviving spouse’s income were to vary at all. Economic conditions and family dynamics change unpredictably, so let’s see what Goldilocks’ dish is all about.
A tailored solution – just right
With the help of software, a financial planner can model out a few possible long-term outcomes to help their clients find a realistic middle ground. Here a planner can test what level of coverage would best withstand stock market volatility, or how an increase or decrease in the surviving spouse’s income would impact the results of the Deluxe Method. It is critical for the advisor to provide sound advice and for the clients to understand how the recommendations relate to their lives, so working with a planner who holistically integrates family and finances over a longer time horizon is key.
What you can do right now
If you are looking over your situation right now and wondering how much you need, the bare minimum is a good place to start and not get immediately oversold insurance. It can be implemented on your own with some straightforward calculations. For a more nuanced solution, working with a financial planner who can test several scenarios that incorporate stock market volatility, will better manage the real risk without being oversold.