Choosing life insurance is not as simple as many make it out to be. While the general rule of 7-10x your income is a convenient rule of thumb, gaining proper protection requires a more thoughtful approach. In this article we’ll discuss what important questions and conversations must take place and use a data driven approach to determine what coverage you need and for how long. We even have a free Excel calculator to help with the process!
Why Life Insurance?
American’s tend to not be a proactive bunch of people. Median retirement savings is about $5,000, almost 40% are obese, and 41% don’t carry any life insurance. While each of these is the result of poor decisions and discipline, the first two take considerable effort and time to correct while only the third can be solved in just a few hours!
Life insurance comes in a variety of forms, but at its core all have one thing in common. The insurer pays a set amount upon the death of the insured. While many advocate whole and universal life policies, we will make all our recommendations around simple term coverage.
Why term? We’re big believers in “Buy term and invest the difference”. Term is a small fraction of the monthly cost of whole and universal, as those policies include investment vehicles. While it may sound good and in some cases are the right fit, the main reason they are pushed hard by financial advisors is because they pay out hefty commissions. Similar to a car lease, at face value it may sound like a good idea but then proves to be one of the worst investments upon closer inspection. Keep your insurance and investments separate!
Having said that, don’t forget that if you buy term, you mustinvest the difference! While you might get all the short-term coverage you need in a few hours, you can’t stay among those in the first statistic with only $5,000 in retirement funds. When term insurance expires, you have no coverage. This is perfectly ok as long as you are working toward “self-insurance”, where your savings will sustain your desired lifestyle for as long as you need (This is otherwise known as retirement!).
One of the biggest arguments against term is that in the real world, people don’t save for retirement so we should “force” them to by bundling with a whole or universal life policy. While this may be a valid point, there are very high costs associated with the “convenience” of this forced savings, so we’d encourage you to minimize your fees and maximize your return by having a solid budget, savings plan, and investment strategy.
The fundamental purpose of term life insurance for the vast majority of people is family protection. We’ll talk through some of the questions to ask in the next section, but all are centered around providing for your family if you and/or your spouse die prematurely. Few things are sadder than seeing someone pass away early and their family having to struggle to survive on top of dealing with the grief of a family loss.
Except for rare occasions, life insurance shouldn’t be viewed as just enough to cover the funeral or so much to make the family wealthy. View it as how to ensure your family has the lifestyle you’d want to provide should you live out the rest of your normal life.
How much coverage
If you’re looking for a quick rule of thumb answer, you’re not in the right place! Our goal is to help you walk through a process of thinking strategically about what you want your life to look like and make a sound, data driven decision. That’s what we’ll discuss during the rest of this article. However, if you’re already tired of reading and aren’t interested in minimizing your monthly cost with our free Excel calculator, just go buy about 20x your desired replacement income ($100k/yr in income = $2M in coverage).
Ok, so let’s get to it!
Emma and I were recently married and this life change prompted us to go through the process of adding/increasing our life insurance coverage. We’re talking from experience!
I already had a group policy through my job at 1.5x my salary, but I wanted coverage outside of work in case my employment changed. I had a smaller 20-year term policy, but the coverage was not enough considering all of the upcoming family changes and I was already 4 years in to the term (16yrs of coverage left). Emma had no coverage.
We started by asking some hard questions about our “life plan”. These included:
- What lifestyle did we want for each of us should one of us pass away?
- How would our children be provided for should something happen to both of us?
- How will our coverage need change over time as our net worth increases, family grows, and jobs change?
The answer to these questions will be unique to each family. Having a solid vision that includes all aspects of career, finances, and family will greatly assist in answering these questions. For us, we knew that even though Emma works now we wanted her to be able to stay at home with the kids once we have them and ensure that she could continue to do this if something should happen to me. I also didn’t want her to have to manage major changes to do so (downsize a house, stop funding kid’s college, sell her car, etc.). For me, I knew that I would need extra finances to replace the tasks that Emma will do as a mother should something happen to her (childcare, housekeeping, errands, etc.), but the intent is that I’d continue working.
In a worst-case scenario where both of us passed, we wanted to ensure that our children would still have the childhood care and start in life that we want to give them (comfortable home, good education, first car, help with the first house, etc.).
Thinking and talking through these questions is difficult as the conversations are uncomfortable and may feel morbid. However, it is absolutely essential if you’re to not only have the right coverage amounts but also have good communication as to what you want your life and family to look like. These discussions are valuable to your marriage even if you live a long, full life!
Considering all of the above, we didn’t base our coverage on our current, comfortable DINK income (DINK = Dual Income, No Kids), but on a lower replacement income. We also had different factors for each of us, as the coverage for Emma was based on the cost to “replace” her, while mine was based on my income as the primary breadwinner post-kids.
Determining how much coverage we needed also needed to consider the time value of money, as the policy’s premium and death benefits are fixed, but inflation makes a dollar next year worth less than a dollar today. We therefore took everything back to today’s dollars (Present Value). Of course, we also figured in the growth of our investments (both from ROI and contributions).
How long do you need coverage?
Term life insurance policies are primarily priced on your current age, health (every policy will require a medical exam with lab tests), length of term, and amount of coverage (death benefit). It makes sense that a $1M coverage for 30 years will cost much more for a 40-year-old man than 20 years of coverage, as the chances of mortality from age 60-70 are much greater than 40-60.
Given the above, we don’t want to pay now for coverage any longer than we’ll need it. There is a substantial cost to getting more than you need for a longer period than you need, even if you cancel it later. You want to set the coverage to drop off as your net worth grows, so you minimize your cost while maintaining the appropriate coverage over the right term. Admittedly, this is tough to calculate on the back of an envelope!
Putting it all Together
Where things get interesting is where our first question of “how much?” intersects with the second of “how long?” intersect.
We headed over to https://www.policygenius.com as they have a great tool that will give you accurate quotes without any need to enter your email. Below are sample monthly premiums for a woman that is young (mid-20’s), healthy, and looking at $500k, $1M, and $1.5M in coverage over 20-30 years.
Below is the same data in matrix form:
|Term/Coverage||$ 500,000||$1,000,000||$ 1,500,000|
|20||$ 16||$ 27||$ 39|
|25||$ 21||$ 36||$ 52|
|30||$ 25||$ 43||$ 62|
If we look at the total premium cost over the life of the policy, it looks like this:
|Term/Coverage||$500,000||$ 1,000,000||$ 1,500,000|
|20||$ 3,840||$ 6,480||$ 9,360|
|25||$ 6,300||$ 10,800||$ 15,600|
|30||$ 9,000||$ 15,480||$ 22,320|
So what does this mean and why is it important?
Let’s say that we determine this person needs $1.5M in coverage over the next 20 years while their children are still at home and in college. After they graduate college and are out of the home, the need for insurance will drop to $1M and then $500k while she is finishing out her career (10 more years). At year 30 she plans to retire, meaning no insurance will be required.
She could get a single $1.5M coverage policy for the full 30-year term, but that will cost a total of $22,320 at the monthly premium of $62. Since that’s a lot, she thinks maybe she should just get the 30-year, $1M policy for $43/mo and a total cost of $15,480. The problem is, she’ll be underinsured by $500k for the next 20 years!
The solution is layering 2 or 3 policies together. Let’s see what that looks like.
We can get just the right coverages needed with the combination below:
|20||$ 500,000||$ 16||$ 3,840|
|25||$ 500,000||$ 21||$ 6,300|
|30||$ 500,000||$ 25||$ 9,000|
|TOTAL||$ 1,500,000||$ 62||$ 19,140|
This is the same $62/mo now, but it is less in total since each $500k plan drops off at 20, 25, and 30 years. This is good if we’re confident we’ll have appropriate net worth at those times, as a single policy can’t be “downsized” once established
Let’s see what happens with another scenario:
|25||$ 1,000,000||$ 36||$ 10,800|
|30||$ 500,000||$ 25||$ 9,000|
|TOTAL||$ 1,500,000||$ 61||$ 19,800|
In this one, we saved a little each month, but our total went up. We did, however, carry the full $1.5M through Year 25, which is a benefit in case things don’t go quite as planned.
However, there is an even better scenario which saves money and maximizes coverage. See below.
|20||$ 500,000||$ 16||$ 3,840|
|30||$ 1,000,000||$ 43||$ 15,480|
|TOTAL||$ 1,500,000||$ 59||$ 19,320|
In this scenario, we save $3/mo while barely increasing the lifetime cost over our previous example, and we pick up the full $1M in coverage through years 25-30! It is a great compromise between cost and coverage.
Our Free Excel Tool
Forecasting your life insurance needs at various points in your life gives you the ability to layer in policies and save on both your short-term and long-term costs. In order to assist with this, Emma created a free Excel calculator. Here’s how it works.
- Input your information
- Review the chart to get a rough idea of how you can layer policies and still meet your need
- Adjust the “Policy Increments” to reduce number of policies to the desired number (in this case we increased from $500k to $1M increments and dropped from 3 policies to 2)
- Use Policy Genius to estimate cost for various policies to get the right coverage at the best price
If you’d like this tool, just subscribe to our email list using the form below and we’ll send a welcome email with a download link to the file.
We hope this discussion on term life was helpful for you. Our hope and prayer is that you’ll incorporate life insurance as part of your overall financial plan to give the peace of mind that comes from knowing your family will be provided for. This type of planning is where long term success starts!
Ira & Emma Nicodemus