Life insurance rules of thumb usually don’t apply to real life

In my experience, many folks do not have adequate life insurance. Most insurance rules of thumb that calculate needs don’t do a good enough job of pricing on this one.

Let’s face it: insurance is boring, but complex; requires you think about your mortality; requires you to also think about an estate plan; and is ultimately something you actually should hope to pay for throughout your contract term but never actually need to use. In other words, you want it to be a complete waste of money, even though it ultimately costs a lot.

It’s understandable that most folks don’t want to think critically about life insurance. But thinking critically is a responsibility you bear if someone else’s quality of life depends on having adequate life insurance if you’re not here.

In a nutshell, life insurance seems to boils down to answering the following questions:

1. If you are no longer here, will someone else suffer financially as a result of your death?
2. If so, for how long?
3. And for how much?
4. Finally, do you care and are you able to do something about?

If you answered yes to the above, you need to calculate the needs. Rules of thumb to obtain insurance are often inadequate. Here are two examples where “rules of thumb” are usually harmful.

1. “Ten (or X number) times your salary should cover need.” This is something that I’ve heard or read a number of times over the years. It’s usually bad advice for a young couple with kids who might have 20 to 40 years of work ahead of them. Further, it’s bad advice for an older couple approaching retirement who have no estate tax issues and are already close to financial independence and may actually have little need for insurance.

   This is only good advice when X times your salary works actually answers the questions above. In all the calculations I have ever done, for example, I’ve never seen 10 times your salary be the answer.
    

2. “Buy term and invest the rest.” Another poorly executed broad-stroke piece of advice. Let me be the first to criticize fee-only advisors (like me) who are often guilty of this broad-stroke advice. Shame on us if we don’t back that generic comment with good hard analysis. For example, this is likely bad advice for:
   1. Someone who might need a lifetime to achieve financial independence. Think younger, high-income folks who also have a lot of debt and might need 30 to 40 years to achieve that independence. A 10 to 20 year term policy simply won’t cut it!
   2. Someone who is going to face a possible estate tax problem either in the form of liquidity or tax offset, or both, and wants to have liquid funds available to address those goals. Small business owners or large estates may face this scenario. One should see a qualified estate planning attorney for this advice and then get plan design and calculations done by a qualified advisor.
   3. Someone who has a child with special needs. A family with a special needs child may need to care financially for that child in rather expensive care facilities for multiple decades if they are no longer here. You may also have federal and state resources outside of the scope of this article that need to be expertly planned for and which no financial planner or insurance agent is completely qualified to do for you since it constitutes legal advice. You should first and foremost seek out a qualified special needs planning attorney, then bring in a qualified advisor.

In all of these cases, the idea of buying some arbitrary level of term insurance or using X times salary is dangerous unless you can be absolutely certain the term will match a plan design 10, 20, or 30 years from now.

(Continued)

To help, here’s an overview to help you think about your possible needs. The assumptions are hard to calculate, but one could price needs as follows: insurance = lump sums to fund + ongoing needs + retirement deficit contribution of the person who passes away.

1. Lump sum needs: You may have some debt to pay off, college tuition to fund, or an estate tax to pay. The debt and college funds have terms to them (they’re the days the debt comes due or college starts) so they’re easier to price. The estate tax is not common given today’s exemption amounts, while it is also a floating number dependent on tax law of when you may pass away well into the future. It’s harder to price.

   PLUS
    

2. Ongoing needs: When you die and someone else is relying on your income to cover lifestyle, you need to price in what that person would need for the number of years until they retire. For a young family, it could be 30 years until you retire. In that case, you essentially need to rely on the retirement distribution rules, only applied to a young family who may have two retirement experiences! See my last article discussion on retirement distribution strategies to help. If you are older and perhaps have just 10 years until retirement, you can more easily see how 10 years could be calculated and discounted by inflation.

   PLUS
    

3. Retirement needs: This often gets missed or is at least not accurately priced to include a very long horizon. Most insurance seems priced to cover while you are working but then doesn’t actually cover what you should or could have saved while working, which could also span 20 to 30 years. You need to price in the opportunity lost of what that person would have made in income. Again, my last article discussion would help you think about this calculation.

As a rule, I generally recommend people purchase a level of insurance as if they were going to die the day after they bought the policy and then price in flexibility to change the coverage downward over time.

Disclaimer alert: There are other best practices and this is by no means meant to be detailed advice; rather, this is to show you the ways to think about your life insurance needs. A good analysis is necessary and in many cases really requires a qualified advisor and insurance agent.

This article also comes from someone who does not sell insurance. I have no agency interest. My obvious bias is that people put together a team to figure this out. Seek out a fiduciary fee-only advisor and also bring in your qualified attorney to review needs. This is especially necessary if the coverage needs are complex, not to mention to confirm beneficiary designations. Finally, a good, licensed insurance agent is also necessary to place your coverage as well. Any purchase of insurance still needs a good insurance agent to provide feedback on the plan, think through company suitability, assist with the underwriting process, and ultimately implement the policy and follow up with beneficiaries.

As in any analysis, every one of the above assumptions can be massaged to your specific situation, while it would also be very valuable to run probability analysis around whatever assumption tracks you use. The primary point above is that life insurance calculations come with a lot of assumptions and it’s very important that you think critically about your needs and bring in the right team to make it happen. Take it seriously because someone else is likely relying on you to do so.

MICHAEL DUBIS is a fee-only CERTIFIED FINANCIAL PLANNER™ and president of Michael A. Dubis Financial Planning LLC. He previously served as a lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at financialperspectives@gmail.com.

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