If there is someone in your life who depends upon your current and future income for financial support, then you probably need life insurance to transfer the financial risk of an untimely death. The proceeds of a life insurance policy can cover your family’s immediate financial needs in the wake of your death, replace lost income, repay debt, and provide for your family’s expenses and goals. While we often avoid thinking about our deaths, life insurance provides some peace of mind knowing that your loved one’s financial needs will still be met in your absence.

Term life insurance is probably all you need

I’ve written previously about why term life insurance is probably all you need (despite what an insurance salesman may say). Level term is the simplest and most cost-effective type of life insurance policy. Term insurance covers you with a specified death benefit for a fixed number of years at a predetermined premium (that’s usually a fraction of a whole life policy for the same death benefit). Once your kids are launched, most people no longer need as much life insurance, if any. By this point, retirement isn’t that far off and you should have built up considerable savings and investment balances. There are situations where a permanent life insurance policy (whole life or universal life) makes sense, but these scenarios will be the topic of another article.

How long should the term be?

The simple answer is that you probably need some amount of life insurance until close to your retirement age, or at least until your children are grown and you’re retirement needs are funded. However, your need will likely decrease with time and as your net worth grows. For this reason, many individuals will decide to ladder two or more term policies. For example, purchase both a 15-year policy that will see your children through college, and a 25-year policy that will provide additional coverage now that extends to later in your career, protecting your spouse’s ability to retire comfortably.

What factors affect how much life insurance I should buy?

Answering this question requires some analysis of your situation. This includes

• Family members and ages

• Your expected income over time (since that’s what we’re replacing)

• Other sources of income or savings that may offset some of your life insurance needs (do you have savings, a working spouse, or family members who could help?)

• Does your spouse work? If yes, would he/she be able to continue in their current employment without you around? If your spouse doesn’t work, would he/she be willing and able to go back to work?

• What are your family’s goals? (provide for college education, maintain your lifestyle and retirement needs).

• Cash flow and budget constraints

How do I calculate my life insurance needs?

There are three basic approaches to performing this calculation. If terms like “present value” and “discount rate” are a foreign language to you, ask for help or use the simple benchmark approach to get a rough answer. Life insurance companies can provide a survey-based calculation and there are numerous calculators available online. If you’re handy with spreadsheets, you can do it yourself. A fee-only financial planner can also help and is often in the best position to provide holistic advice given their understanding of your entire financial position and goals. (A fee-only advisor also isn’t compensated by commissions, so they have no conflict of interest here!)

• A simple benchmark approach: multiply your gross pay by 12-18x. If you are still relatively young and in the accumulation phase of your career with a relatively low net worth, this benchmark is going to be a pretty reasonable approximation.

• The “human life value” approach: this morbidly named calculation sums up the value of your future earnings through retirement age and converts them into today’s dollars by applying a discount rate to account for inflation and expected investment returns. More specifically, this calculation takes the present value of lost future income (adjusted for taxes and personal expenses of the insured as well as the expected growth in income) through work-life expectancy.

• The Needs Approach: This is the most involved way to calculate your insurance needs since you’ll estimate the future cash needs of the family after the insured's death (instead of just looking at lost income). To do this correctly, you’ll need to estimate final expenses, elimination of debt, the present value needed to fund specific goals (e.g. college tuition), the present value of the future income needs of the surviving spouse and family, and the present value of retirement needs of the surviving spouse.

Depending on the method you use (or your advisor uses) there are a lot of variables to account for here, so beware of false precision. It’s also important that the amount you choose feels right to you and your family. Of course, we hope this exercise will never be put to the test!

No amount of money can replace a human life, at least that's what I tell my wife so she doesn't try to get rid of me prematurely...