Life Insurance: Why People Choose the Wrong Amount
Today I read another “rule of thumb” about how much life insurance coverage we should choose. Please…I’m running out of hair to pull out.
Life insurance, for most people, exists for one reason: to create an asset base that you don’t yet have which will allow those loved ones you leave behind to live comfortably after you’re gone.
If you accept my definition of why life insurance exists, ask yourself this:
How the heck does anyone with a rule of thumb know the answer these questions:
What size asset base does your family will need?
What does “comfortable” mean to you (and those you leave)?
How long until they retire/go to college/need the cash?
What does your asset base look like now?
You can see why “rules of thumb” make me want to vomit. They’re not just idiotic…they’ll cost you either thousands of dollars in wasted insurance OR you’ll leave your loved ones with less than they need.
Stay away from rules of thumb.
In the “big boy world” where we don’t rely on the diapers that are “rules of thumb,” we do something that really ain’t that hard. We do the freikin’ math.
There are two computations you’ll need to do. First, you’ll need a capital needs analysis. Second, you’ll need to figure out human life value.
Capital Needs Analysis
Don’t be fooled by the name. All you’re doing is figuring out the bottom line “need” that your family should cover with insurance to survive without you.
1) Take out your current budget (don’t stumble on this one!)
2) Refigure the numbers without you. How big is the budget now?
3) Figure out how much your family will need for goals. What do they need to save for retirement, college, etc?
An aside: If you’re married, don’t be an ass and assume your spouse is going to get re-hitched when you pass away. When I was an advisor, I had some dumbs$%!s tell me that, and I about laughed them out of my office. I don’t care if your spouse gets married after you die. I just don’t want her sitting at a singles bar waiting to slow dance with the guy in the Babylon 5 tee-shirt because it’s in the flippin’ plan. Be a grown up and take care of your spouse.
4) Check the budget against the goals. Is there enough to save AND reach the retirement/education/savings goals. If not, track the shortage and add inflation each year.
5) Backtrack all the shortages (if any) to a sum today that would meet the need.
6) Subtract from any shortage the amount you already have saved and a reasonable cash amount for the stuff your family will sell.
7) Boom. Any shortage left? If so, you’ve just figured out how much (if any) life insurance is your bottom line “need.”
Why Capital Needs Analyses Are Awesome
A capital needs analysis is great because it gives you a bottom line number based on your own goals. No rule of thumb, no “buying what some life insurance agent told me to get.” You have an actual number.
Why Capital Needs Analyses Stink
Go back to my six points. ALL of these numbers are blowing in the wind. The second you look at “what your family needs to retire without you,” you’re betting on inflation, rates of return on investments, and future behavior of your loved ones. Can you predict any of this? To a degree, yes. However, you and I both know this number will be wrong.
That’s why we don’t stop there. We also perform a Human Life Value Analysis
What Is a Human Life Value Analysis?
Human life analysis looks at the amount you’re worth, in terms of “bringin’ home the bacon” if you were to die tomorrow. Have you ever seen those wrongful death lawsuits where a family is awarded millions of dollars? The big fight between the family and the insurance company isn’t just guilty/not guilty. It’s actually about how smart the deceased was about managing their own money.
In human life value you assume that a person would continue to earn money if they were to still live a normal life through retirement. You also assume they’d retire at a reasonable age, which usually is 65. Then you assume that the deceased would receive reasonable raises.
All that human life value represents is the sum that you’d earn throughout your life, present valued to a single pot of money today. In short: how big a pot of money today would make up for the family’s loss of your income.
Another aside: families and insurance companies often switch sides during a human life value argument in court. The family, hoping for a bigger pot of money, pretends they’re a bunch of morons who don’t know investments. Why? An investment savvy family might receive a smaller award because the assumed return on this money will make up the difference. The insurance company argues that the family is incredibly savvy, so that they can award a smaller check (because the family will be able to make up the difference in funds through investment returns).
Human life value numbers, as you can imagine, are huge (even if you are investment savvy and assume you’ll earn 8% on your pot of money).
How Much Life Insurance Should I Buy?
Now you have two numbers. The capital needs analysis produced a number that is small and “blows in the wind” because of the big number of perilous assumptions. The human life value number is usually a larger number, but assumes you’ll need the deceased’s full paycheck to continue living. That’s improbable.
The Field Goal
I used to perform these two calculations for my client and told them that now they needed to kick a field goal. If you’re not familiar with football, a field goal is a kick between two upright poles. Your correct amount of insurance is somewhere between these two number “poles.” From here on out, it’s more art than science. How do you feel about your need?
Generally, people chose a number closer to the capital needs analysis. Low end. That’s what I did. However, I had clients who wanted to be midway between the numbers and one family who only felt comfortable at the human life value number. There is no right answer here. My clients who chose the smallest possible number would have been unhappy with more insurance. The ones who chose the full human life value would have had trouble sleeping at night with less. Just realize…insurance isn’t free, so whatever you choose, realize that it’ll affect either the budget today or the amount your family receives if you predecease them.