How Much Life Insurance Do I Need?

by Mike Holman

Calculating the amount of life insurance you need is a lot like planning for your retirement. You need to figure out your financial goals, calculate how much income is necessary for those goals then figure out how much money you need to make that income happen.

Please note: this only applies to term insurance. Universal insurance (which I don’t recommend by the way) is an entirely different product. Term insurance is insurance where you pay a monthly or annual premium for an amount of insurance for a set amount of time which will be paid into your beneficiary if you die. For example someone might buy $250,000 of insurance which is valid for ten years. If they die within those ten years then the $250k will be paid to the beneficiary or the estate.

Calculate how much life insurance you need

I’ll use myself as the example on this calculation. My wife doesn’t work and we decided that our goal for life insurance was to get enough to ensure that she wouldn’t have to work again. This doesn’t mean retiring in luxury but making enough money to pay the bills and hopefully have a similar standard of living to what we have now.

Annual Living Expenses

First thing to do is figure out how much money is needed to maintain our current lifestyle. We kept track of our expenses for the first six months of this year and determined that our basic living expenses are about $32,000 per year. This does not include mortgage payments or any other debt payments since they will be paid off with the insurance. Since the plan is for my wife not to work and she won’t qualify for any government pensions for quite a few years we need enough insurance to be able to pay off our debts and then generate $32k net income per year which is about $35k gross assuming a portion will be coming from Canadian dividend stocks. I’m assuming that any of the $32k in expenses that are because of me, will be able to cover expenses for our one child. If you have more kids then you might want to increase the annual amount to compensate for this.

Required Portfolio Size for self-insurance

How much do you need to generate $35k per year? The normal figure for retirement planning is to use the 4% rule. I think for this purpose assuming that you can take 5% of a portfolio is safe enough that you won’t run out of money. So therefore $35k is 5% of $700,000. We need enough insurance to make sure that we end up with a portfolio of $700k and no debts. If my wife worked then I would subtract her income from the $35k amount.

Currently we already have a portfolio of $230k and our debts are about $200k.

Therefore: insurance needs = final portfolio amount + debt – current portfolio = $700k + $200k – $230k = $670,000. In fact I have about $750,000 of insurance which is too much.

Summary:

  1. Calculate a gross income desired according to your financial goals. Use taxtips.ca for guidance regarding taxation amounts.
  2. Use the following formula: insurance amount = (gross income desired – survivor income) / 0.05 + total debt – current portfolio.

A couple of points. I use the divisor of 0.05 but if you want to be more conservative then use 0.04 (4% rule).

I’m assuming in my example that the beneficiary is reasonably young and won’t collect any type of pension for a long time. If the survivor will be older ie 50+ then you might want to increase the divisor to 0.06 because they will be eligible for government pensions which will eventually reduce the amount of insurance income necessary.

When I talk about taking 4% rule or 5% rule this refers only to the amount of money withdrawn from the portfolio in the first year. Every year after that is the initial amount adjusted for inflation. Ie in the example above, the withdrawal in the first year is $37k. If inflation is 3% then the withdrawal in the second year is $37k + 3% = $38,110. In the third year you would take $38,110 = 3% = $39,250.

You’ll notice that two of the main factors in determining the amount of insurance needed are current debt and current portfolio value. Because of this there is no point in stressing out about the perfect amount of insurance to get because that ideal amount will change every year. This is why you don’t want to get too much insurance – more about that tomorrow. Generally speaking if your debt is going down and your investment portfolio is going up then your insurance needs are going down so if you buy too much insurance today, then in a few years you will have way too much insurance.

Another thing to avoid is to have too much insurance for too long. You might need $750k or even a million dollars according to your plan but you probably don’t need it for 20 or 30 years. Try to figure out how long you need this insurance for and buy accordingly. In my case I bought $500k for 10 years (plus $250k I already had from a group plan) and after that I might only need $250k for about another 5 years or so. Once I’m retired or close to it (hopefully in about 15 years) then I won’t need any insurance at all because our debts should be zero and our investment portfolio will provide all the necessary income.

Why Over Insuring Is Like Buying Lottery Tickets.

More info

Senior Term Life Insurance

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{ 19 comments… read them below or add one }

1 TheFinancialBlogger

This is a great analysis but you forget one important factor: your child! Unless you included his future financial needs through your expense, you might wan to consider an amount for his tuition and also to appreciate the fact that he will cost more over time (I’m thinking about clothe and food once he is a teenager;-) ). So the fact that you have 750K might not be too much, the extra 80K would cover for that.

Man, that was a lot of work to write this post!

2 Four Pillars

FB – thanks – I changed the post to reflect this. I’m assuming that any of the annual costs that are because of me will go for my child in the future if I die.

Mike

3 Mr. Cheap

Great post. I didn’t follow why you used 5% instead of 4% (I thought the 4% withdrawal rate was commonly accepted for retirement, with a diminishing principal, so if you were going going to be using this for a young person you should use a LOWER withdrawal rate, not a higher one, right?)

Do the expenses you’ve accounted for not already include your child? How does the expense of a child (at different ages range up to 18) compare with the expenses of an adult? I’d assume it would be less the whole time (can teenagers really eat THAT much? 😉 ) since they won’t have a car, be going on trips, etc. Given this, it seems that tweaking the amount to remove you and add in the child might be a valuable exercise (and might justify a lower amount).

I’ve never bought life insurance (term or otherwise). How “fine grain” can you buy it? Can you get $750K or $670 or ($554,382) or does it come in discrete levels?

It’d be an interesting product that would automatically drop the pay out (and expense) as time goes on to compensate for your growing portfolio and debts.

4 telly

Imformative post.

At this stage in our lives, my husband and I have minimal group coverage through work (1.5 times pay). We have no dependants and could each afford to pay the bills on our individual salaries alone if something were to happen to the other. But I wonder…

is there any truth to getting individual coverage early due to cheaper dues for being younger, rather than trying to get individual coverage later in life (say mid to late 30’s) or is this just a scare tactic?

5 FourPillars

Mr. C – I actually wrote the beginnings of a post this morning where I propose exactly what you mentioned – a life insurance product where you can lower the insured amount over time to suit your needs. I guess that’s why we are sharing a blog! I don’t know much about purchasing insurance but it seems that it’s not that flexible in terms of amounts and time lengths.

You’re right about the child expenses although to be honest, in my case I don’t think we have spent a penny on our child because of the generous grandparents and friends (hand-me-downs). That sort of calculation would be part of the financial planning in terms of goals – how rich/poor/average do you want your family to be if you die? If you want to plan for all your kids to attend Harvard – then go ahead and plan accordingly.

As for the 4%/5% – I’m not sure it really matters too much considering all the unknowns in this type of planning, but technically you are correct that 4% is the better figure. I don’t really have clear reason for choosing 5% other than that 5% is not an unreasonable figure.

In my case, the assumption that my wife wouldn’t ever work is probably not true, which will change the figures quite a bit. Another big unknown is whether the surviving spouse will hook up with someone else – I’d be interested to know what the stats are on that. Another factor is the house – you probably don’t want to plan on the survivor having to sell the house and downsizing but it’s always an option.

Mike

6 Canadian Money

One thought
If one has a mortgage with life insurance coverage on the mortgage, then the house payment will disappear… reducing the need for addtional income loss insurance. Are mortgages were always covered by life insurance.

CM

7 Sods

Excellent, I was just searching yours and other linked Blog’s for information on Life Insurance yesterday. I will await the continuation anxiously.

Sods

8 FourPillars

Telly – that’s an interesting question. I recently got $250k of coverage for 10 years for $227/yr which seems quite reasonable. I don’t know what a younger person would pay in comparison.

A younger person would pay a smaller premium but if they don’t really need the insurance for five years (ie until they have kids) then they are paying a lot more than they need.
I guess the risk (however unlikely) is that you might develop a condition between now and when you need the insurance ,which will prevent you from getting that insurance or might result in much higher premiums.

Personally I’d say wait until you need the extra insurance (ie if you are preggars) before getting it.

Mike

9 FourPillars

CM – the calculation refers to the total amount of insurance you would need so if you have any from work or for your mortgage then you should include that in the total. Also – mortgage insurance can be more expensive than term so you might want to investigate the difference.

Sods – there is no part II planned although I am posting next week on why you shouldn’t be overinsured. Do you have any questions or issues you would like to see covered?

Mike

10 the Wealthy Canadian

Something to consider is taxes. Your insurance payout is tax free (since it’s bought with after-tax money) however your annual income generated by the insurance payout is still taxable. $32,000 generated solely by dividends would not have any (or much) tax and has the added benefit of (ideally) increasing with inflation. But interest from bonds would be taxed at the full rate therefore you’d need to invest more to get the same income stream of $32k.

Buying a 20 year term would insure you for the duration of your children living with you (i.e., your high expense segment of your life) and is cheaper than Universal. You would also be buying it when young and healthy so the premiums should be cheaper.

Telly – it is my understand that the insurance is generally cheaper the younger you are. It all comes from the actuarial tables. Statistics show you have a higher chance of dieing the older you are, so they charge you for that increased risk.

11 Mr. Cheap

Another factor to consider is you don’t want the payout to be TOO generous, as this may give your dependants an incentive to knock you off 😉

12 Sods

It was a very well written Post, I like the way you post to get the most info across in an easy to read format and length.

I do have one question, my family has a history of cancer and heart problems, usually developing in their 40-50’s. I am currently 23, so would I be better to over-insure now and lock-in for 25-30 term, just to make sure i don’t get denied in 20 years time, when i will probably have kids and a larger house?

13 FourPillars

Mr. Cheap – excellent argument against getting too much insurance!

Sods – Thanks for the compliment.

I really can’t give a definitive answer to your question – I do know from my own experience that insurance companies will factor in your relative’s health issues in the premiums regardless of your age so you might already be looking at higher premiums than someone with a healthier family. As far as trying to “plan ahead” by buying insurance now – the insurance companies can analyse your risk far better than you can so I don’t know if you will come out ahead by doing it now. You might be better off to put the premiums to work and pay down your mortgage, increase investments etc. The best type of insurance is to have strong personal finances and to not need any insurance.

Maybe we’ll hear from some real insurance experts out there on Sods question?

Mike

14 telly

“As far as trying to plan ahead by buying insurance now – the insurance companies can analyse your risk far better than you can so I dont know if you will come out ahead by doing it now. ”

That’s a very good point Mike.

15 FourPillars

Thanks Telly – one thing I learned when I got some insurance this year is that the company will do a telephone interview with you and ask about a million questions regarding your health, your parents, siblings etc health and various habits and activities. It took about 20 minutes to get through it all so they do have some data to work with. They will also get your health records from your doctor and they do a blood test and weigh you as well (they bring the scale).

Mike

16 Nurseb911

For what its worth…

I have no dependents, but I still took out a hefty life insurance policy (dirt cheap through work) in the event that something ever happened. My will is set up to construct a trust for my two younger siblings through which they’ll receive percentages of the estate every 5 years past their 25th birthdays. I wanted to make sure if something ever did happen that they would be taken care of.

17 Four Pillars

Nurse B – that’s a very generous way to take advantage of a cheap policy from work.

Mike

18 Steve

While I agree that your assets go up and debt goes down over time – reducing your need for life insurance, there’s also factors like inflation and income/lifestyle increases that increase your need for insurance. That doesn’t mean you should overinsure, but it does mean that you might just want to have one, level term policy.

Also, I would add in some margins of safety if things don’t go according to plan. You might expect to only need 250k for 5 years – but then end up needing it for 6 or 10 or whatever. Again, don’t go crazy overinsuring, but don’t ride the razor’s edge either.

Also, IMHO the time to get life insurance for your future kids is when you start trying to conceive them. There can be a bit of a delay between conception and you finding out about that conception – you wouldn’t want something to happen in that time span and leave your spouse in trouble.

19 Mike

Steve, you make some great points. Even low inflation over a long time period will have a great effect.

Very true about getting insurance because of kids asap – there isn’t any benefit to delaying this.

Thanks for the great comment.

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