Life insurance.
The ultimate Active Keep strategy.
Like the old saying goes, “You can’t take it with you,” but you can direct who it goes to!
Determining why, or how much life insurance your client needs is a very personal discussion, literally a matter of life and death. Most responsible adults have life insurance for a number of reasons, including:
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To take care of loved ones you will leave behind,
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To fund an Investment Completion Plan,
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To avoid saddling your loved ones with burial costs, and
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Create an instant estate, and minimize the effects of “estate shrinkage,” the depletion of your non-insurance financial assets from taxes, probate, fees and final expenses.
Life insurance planning revolves more around “who?” than “what?” or even “how much?” What type of life insurance to buy, and how much, are important consideration, but as in all life’s great decisions, it’s the people in your life that are going to drive your ultimate insurance choices.
First, consider who relies on the insured’s income. If they are single, probably nobody. But married with kids? Start counting the heads! Their dependents are just that, dependent on their ability to earn. Of course, that dependency doesn’t end when one dies.
So it’s vitally important to look at your client’s life like a commodity with intrinsic value, and then capitalize that value. For instance, what is the capital value of a worker who earns $75,000 a year, increased by at least the annual inflation rate, for the next 35 years? It’s in the millions.
But back to death.
Death ends our ability to earn.
It’s a fact, look it up!
So, being responsible family stewards, we buy life insurance. There are several issues to consider when doing so, such as what type is best, who should own the policy, coordinating beneficiaries designations with your estate plan, and many others, which we will deal with in future posts. This post is about “how much do I need?”
This is an important and complex question.
There is no off-the-shelf answer, but let’s do a brief exercise to illustrate the decision-making process.
Let’s say you have a family of four, a thirty-two year old spouse and two young kids, and you have been living comfortably on your $75,000 a year income. You’ve been saving in a 401k (passive make, naturally) and started college funds for both your three- and four-year old. Then, you die. Your family needs to have a $75000 income to keep things moving along.
For young widows and minor children, Social Security becomes vitally important. In practice, based on individual circumstance, the numbers change based on the family variables, and the formulas to calculate are beyond the scope of this article, which focuses on how to determine the right amount of life insurance coverage.
Essentially, we use a “shortfall” method. For our purposes, let’s say social security brings home $2100 a month. That’s about $25000 annually. At that point your family is facing a $50000 income shortfall. Yes, it’s a big number.
Let’s say that between retirement and taxable savings accounts there is enough to generate another $4000 a year. The income shortfall is down to $46000 a year. Yes, it’s still a big number, and while you have been good about not having debt, there is still a mortgage balance of $150000.
So, from this simplified planning scenario, we need to bring the family enough money to pay off the house (a must) and generate about $4000 a month in income.
A $150000 term life policy on the life of a young adult to cover the mortgage is cheap. This is a slam dunk decision and should be part of every financial plan.
A permanent policy that pays your beneficiary $2 million creates an instant liquid estate that can generate $48000 a year, at 2.4% interest, with no reduction in capital. At higher interest rates, a smaller amount of coverage can still do the job.
Of course, a major decision will be how to invest the insurance proceeds so that the money can last the family as long as necessary, take care of minor children until they are of age, fund higher education accounts, like a 529 Plan, and set up the surviving spouse, especially if they’ve had to suddenly change their career plans.
For many, life insurance is an unpleasant subject, for obvious reasons, but its an important foundational discussion for every couple to have, especially when there are children to care for. On tight budgets it may be hard to justify the cost at first, but insurance premiums are one of the best investments one can make for the long-term welfare of their family.
The more insurance coverage your client can afford, the better the chances are of generating a comfortable income for their family, should they pass.
And that’s the whole point.