How Much Coverage Do You Really Need?

Unpredictable investment and job markets are rough on retirement planning. They also complicate the issue of how much life insurance is right for you.

Standard formulas -- such as buying coverage equal to eight to ten times your annual income -- are inadequate shortcuts. Online calculators are apt to tell you to raise your coverage by $1 million even if you already have insurance. The truth is that life insurance is a personal affair. Two couples may earn equal salaries, but it?s silly to say that someone with four young children should have the same coverage as empty nesters with no mortgage and a substantial retirement fund.

Low inflation and a recovering stock market may tempt you to low-ball your life-insurance needs. But other financial realities, such as puny yields on reinvested lump-sum benefits, may require that you have more coverage, not less. And you?ll likely experience life events that call for changes in your insurance: marriage, parenthood, homeownership, college expenses and retirement. Instead of relying on rules of thumb, you?re better off taking a systematic approach to figuring your life-insurance needs. That?s easier than it sounds, as you?ll see from the following process, because it ?truly is an art as well as a science,? says Tim Maurer, a financial planner in Hunt Valley, Md., and coauthor of The Financial Crossroads (Companion, $25).

A simple strategy. The purpose of life insurance is to allow your family members to pay the bills and live their lives as planned despite your absence. That?s why some experts and most online calculators sponsored by the insurance industry seek to figure the chunk of investment capital it would take to replace all of your income for 20 years or longer, held securely in Treasury or municipal bonds and certificates of deposit. With savings yields low and the prospect of longer life expectancies in retirement, this approach tends to aim high, especially if you assume raises and promotions. ?You can find people who are extremely minimalist with insurance recommendations,? says Maurer. ?But I see an overabundance of people who end up justifying more insurance than I think is reasonable.

Instead, he offers a simple strategy to calculate how much coverage to buy and to form a plan that?s easy to update. The idea is to assess whether you need extra coverage or different policies only after you project your life-insurance needs as the sum of four categories.

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Final expenses. A funeral, burial and related expenses tend to cost $10,000 to $20,000. Your beneficiaries may be able to get the tax-free proceeds from insurance faster than if they waited for money from your estate. Use $15,000 as a ballpark number.

Mortgages and other debts. Total your mortgage balance, car loans, student loans and any other debts that would be a heavy burden on your survivors. They may choose not to retire the mortgage, especially if the interest rate is low, but the money should be available so that they won?t face the prospect of being forced to sell.

Education expenses. This calculation can be tricky because you need to consider the cost of college at the time your kids enroll. But Maurer devised a simple solution. College costs have been rising by about 5% a year, which is the same rate he conservatively expects life-insurance proceeds to grow over time. He recommends looking up current costs for colleges you?re considering, deciding whether you want the insurance to cover all or a portion of the tab, and adding the amount in today?s dollars to your life-insurance calculation.

Income replacement. Once you cover funeral expenses, debts and education, your family won?t need to replace 100% of your income -- and that?s where the art part of the calculation comes in. Maurer recommends covering 50% of current pretax earnings until retirement. You can translate this into a target lump-sum benefit by dividing it by 0.05. For example, if you earn $100,000, divide $50,000 by 0.05, which works out to $1 million. That assumes the insurance benefits will earn 5% a year over the long haul, a conservative back-of-the-envelope figure.

Add all four categories to estimate how much life insurance is appropriate, then tweak the number to reflect personal circumstances. You might increase it if you don?t have a pension, but you could decrease your coverage if your spouse earns a substantial salary. If you or a family member has a troublesome medical history, add $100,000 or even $250,000. If you?re the one with the medical condition, you?ll find it tough to buy additional coverage later at a price you can afford.

For most families, this exercise will work out to an amount in the high six-figures, possibly even $1 million or more. But don?t be frightened. With term insurance, boosting your death benefit by hundreds of thousands of dollars should cost just a few hundred dollars a year.

For example, a healthy 40-year-old male nonsmoker might be considering a 20-year, $500,000 term policy for $360 per year. But he could buy $850,000 of coverage for $576, or a $1-million policy for $645, says Byron Udell, owner of AccuQuote, which represents dozens of life insurers. Women pay less -- just $311 per year for $500,000 in coverage and $558 for $1 million. It?s not as easy as it used to be to qualify for the absolute lowest rates. You can get prices from dozens of companies at www.accuquote.com or www.lifequotes.com.

The time factor.Also consider how many years you?ll need insurance. If you?re in fine physical shape, you can buy a new policy and lock in the price for 20 years. Because prices for term have been dropping steadily, you may not pay much more to extend your coverage if you reshop in, say, five years.

Some term policies come with the right to convert to permanent life insurance, which you can keep for the rest of your life regardless of health. Premiums will be higher than for term at the beginning, but they usually remain level indefinitely. The best reason to consider whole-life or universal-life insurance isn?t the accumulating cash value, although that?s part of the deal. The real issue is whether you?ll need coverage beyond 20 or 30 years -- or after age 65, when term gets expensive. You might want permanent insurance, for example, if you need to protect kids with special needs who will always rely on you (or your estate) for support, or if you want to leave money to a school, charity or your children and you don?t expect to afford it any other way.

You need more life insurance if you...

Tie the Knot.Your new spouse might depend on you even if he or she earns as much or more than you do.

Have a Child.It takes a lot of money to raise a child--and it doesn't get any cheaper if you're not around.

Buy Your Dream House.When you settle into your family's permanent home, guard against its loss in case tragedy strikes.

Are About to RetireNo more insurance from work. If you die, your spouse could lose pension and some Social Security income.

Term vs. permanent: Get the best of both

Term insurance is popular because almost everyone can afford plenty of it. Some young people buy the amount of permanent insurance that fits their budget, rather than the protection they need. That?s not smart.

But it can make sense to combine term and permanent insurance with multiple policies or by buying a convertible-term policy and making a series of conversions over the years. One advantage of a convertible-term policy is that insurers don?t require a new medical exam when you make the conversions. That essentially gives you a pass if you gain weight, develop high blood pressure or even survive a bout with cancer.

Northwestern Mutual Life provided this example for a 27-year-old man who starts by paying $317 for $500,000 of term insurance, and then gradually converts it to whole life $100,000 at a time. If you shift $100,000 to whole-life at age 28, your annual premium would jump to $1,300. If you shift another $100,000 at age 31, your premium would rise to $2,600. Your premium would gradually increase whenever you shift money to the whole-life policy, topping out at $7,200 at age 40, for the entire $500,000 of whole-life insurance.

As long as the insurer remains strong and solvent, the policy?s cash value will rise every year, as will the death benefit. By age 65, in this example, the benefit is projected to be $990,000 and the cash value $475,000, which can be borrowed, withdrawn or tapped to keep the policy in force without paying additional premiums.

This kind of flexibility is attractive to Nirmal Bivek, a 32-year-old banker in Atlanta, who bought slightly more than $1 million in life-insurance coverage when his 3-year-old daughter, Sarina, was born. Bivek has already converted some of the coverage to whole life and expects to convert more of it as his income grows.

He added more insurance when he and his wife, Vijal, were expecting a second child and when they bought a vacation home. ?I?m in good health now and term is cheap,? says Bivek, ?so I?m buying as much as I can now and converting it over time.?