Average Joe and OG hate rules of thumb. Particularly with life insurance. In fact, on a recent Stacking Benjamins podcast, Joe said that his most-hated (and OG’s second most-hated) rule of thumb was the one often spread by the life insurance industry – that you need 10x your income in life insurance.
I think the list was done partially in jest. But if I can interpret their main criticism, I would agree that blanket rules of thumb aren’t helpful for personal finance. Personal finance is – after all – personal.
So, if like Joe and OG, you find yourself looking for a little more insight into how much life insurance you need, read on. Last month was, after all, Life Insurance Awareness Month – so if you missed it (or even if you didn’t….) now is a better time than ever to look at your policies.
The 4 Percent Rule…and Insurance
You may be familiar with the 4 percent “rule” for retirement. Introduced in the mid-1990s by a financial planner, the 4 percent rule tells investors how much of their portfolio is “safe” to withdraw each year without depleting their all-important nest egg. The math behind the calculation says that if you withdrawal just 4 percent of what you have saved and adjust that mount for inflation each year, your nest egg could last more than 30 years (particularly if you leave your equity allocation higher). What we want to do is convert that same principle of the never-ending cash flow to life insurance, and we get a better “rule of thumb” for how much life insurance you need.
How do we do it? Drum roll…
Step 1: Make a hypothetical budget of what the family finances would have to look like to maintain the same standard of living. What does that added income (each month or year) convert to on a daily basis?
Step 2: Take that daily amount and add four zeros to the end. So, $50 daily becomes $500,000 in life insurance; $100 becomes $1 million; etc.
Step 3: Buy that amount.
Let’s think about the math: 4 percent of a $500,000 policy is $20,000 a year. For 365 days, that gives your family $54.79 per day.
Why is this a better “rule of thumb”?
Many times when we in the life insurance industry recommend 10x income, we add in disclaimers that families should also buy enough additional coverage to pay off debt and any major upcoming expenses. So basically, it is 10x your income plus your mortgage.
Oh, and if the kids are potentially headed to college, you should add in that amount as well. And don’t forget to account for the fact that you may have new expenses – like childcare if a stay-at-home parent is lost. I don’t mean to call into question the intention behind this “rule.” The rule’s purpose is noble, and even $100,000 of life insurance is a million times better for your family than none. However, if we’re talking about a rule of thumb, having all these asterisks involved can often be more confusing than enlightening.
Instead, the “daily living expenses” method takes into account all those factors – the mortgage, continuing the same savings rate, etc. – to give a “clean” recommendation that is personalized to each family. If you calculate what that hypothetical budget would look like without a parent or spouse’s income, it should factor in childcare needs and continuing the same college or retirement savings path. You won’t have to add that in at the end.
Is this method perfect?
No. For instance, if one parent believes they may take an extended period off from work after losing a spouse, that amount still wouldn’t be accounted for in this method. You’d have to add that in.
But I think this “rule of thumb” is still better for one main reason: to find the perfect amount, you have to do more than just look at last year’s W-2 and multiple it by 10. It forces families to have a conversation and think about what is often unthought. And it brings back the personal to personal finance.
Jeremy Hallet is the CEO of Quotacy, an online life insurance agent. Quotacy offers free online quotes and life insurance calculators without requiring any personal contact information. Get your free quote at www.quotacy.com today.