How Much Insurance Do I Really Need?

We have already noted that the typical American needs more life insurance protection in his or her early years than in later years.  Why is this?  The need to replace the lost income of the deceased person is obviously greater when children in the family are younger and still need to be supported and educated and/or where the surviving spouse needs or desires to be at home with the children.  Also, if you proceed with the Retirement Planning outlined in this book, you will be accumulating significant amounts of wealth by your later years to either live on or pass on to your heirs.  Let's look at an example.

Example:  Mark maintains about $500,000 of Term life insurance coverage.  He thinks that is a lot, maybe even an excessive amount of coverage.  In reality, Mark is significantly underinsured.  Let's look a little more closely at the underlying facts.  As a professor, Mark generates a very nice income of about $100,000 per year.  However, that money goes fast with six children to raise and educate with the oldest two in college.  Mark's wife, Debbie (the real worker in the family) is at home with the kids, organizing and providing for them.

A simple but relatively accurate rule of thumb in measuring Mark's life insurance needs would be to calculate a principal amount that at a fairly high rate of return would generate enough income (without touching principal) to make up for his lost income.  Let's take a 7 or 8% rate of return, which would be a fairly good number for a relatively safe stock and bond mutual fund like the TIAA-CREF Managed Allocation Fund described back on page 90.  It would take a $1,250,000 of life insurance proceeds invested at 7% to throw off $100,000 of income to replace my lost wages.  Mark would like to leave the $1,250,000 of principal alone so that Debbie would have that amount when she reaches her retirement age as a substitute for the wealth Mark would have accumulated under his qualified retirement plans and IRAs if he hadn't died.  If Mark were a very risk adverse individual who would not trust the mutual fund to provide a relatively steady 7 or 8% rate of return, and instead wanted a guaranteed rate of return as would be provided under a government bond returning 3.5 or 4%, Mark would need to double again the amount of my life insurance coverage.

As the children get older and through college, and the corresponding expenses of raising the kids and my wife's need to be at home with them decline, Mark can start tapering off the amount of life insurance protection.  Again, remember that Term life insurance gets more expensive the older we get so this decline in coverage would correspond nicely to the cost of the underlying insurance: as the insurance becomes more costly, Mark needs less of it.

So you see from this Example how very underinsured many of us are.  The only way that most of us can afford an amount of life insurance approximating what we really need is to buy Term life insurance.