Making Progress Toward Buying Our Life Insurance

By Pinyo, on June 13, 2008

A while ago, I met with an insurance sales agent and discussed life insurance coverage for my wife and I. Three months later and I am still looking — I am a little slow making these big financial decisions. Also, I am not rushing because I already have a $560,000 term life insurance policy through my employer. However, I am looking for two reasons: (1) I want an insurance policy that’s not dependent on my employment, and (2) I am still about $300,000 short based on my eFinPLAN report (see my eFinPLAN review).

Calculate How Much Insurance I Should Have

I mentioned in the article above that I wasn’t satisfied with the calculation provided by my insurance agent. So I did some recalculations, which you can see below.

Paid Off Amount

First, there are three things I would like to be paid off upfront if something happened to either one of us:

1. Final Expenses ~$15,000
2. Debt ~$20,000
3. Mortgage ~$135,000

Adding these up, they come out to be $170,000.

Living Expenses

To calculate living expenses, I tallied up our monthly expenses, which include: food, 529 savings for our son, day care, real estate tax, utilities, telephone, Internet access, cable, insurances, dental, medical, and miscellaneous. This sum matches up to what’s reported in Mint.com nicely.

Next, I compared our monthly expenses to each of our after tax income. As it turns out, I could cover the expenses with my income if my wife died, but my wife would be about $3,000 short each month if I died. In order to cover this shortfall, my wife would need investments that generate $3,000 per month, or $36,000 per year. With her investment skill, we believe she would be able to earn 5% annually. Lastly, we estimated that she’d be paying about 25% of that gain in taxes. Based on these three variables, I calculate the amount needed to generate $3,000 per month as follow:

amount needed x return on investment x (1 – taxes rate) = $36,000

amount needed x 5% x (1-25%) = $36,000

amount needed = $36,000 / 5% / 75%

amount needed = $960,000

Another approach is to follow the 4% safe withdrawal rate for retirees:

amount needed = $36,000 x 25

amount needed = $900,000

Total Coverage

Based on the calculations above, the total coverage adds up to $1.13 million ($960,000 + $170,000). So our plan is to buy a $1 million term life insurance policy for me, and a $250,000 policy for my wife.

I was on the fence regarding 20-year term versus 30-year term, because (1) 20-year term is about two-third the cost of a 30-year term and (2) our finances could be drastically different in 20 years. However, after talking it over with my wife, I think we will go with the 30-year term.

Variables That Affects The Coverage

From the example above, there are several key variables that affect the coverage amount.

1. Paid off amount — For us it’s $170,000 for debt, mortgage, and final expenses. This will be different from person to person.
2. Expenses – I kept the expenses fairly high so that my wife wouldn’t have to change her lifestyle drastically. On the other hand, I didn’t factor in the expenses of a second child or inflation either. For example, if our monthly expenses were $1,000 lower, my wife would only need $640,000 instead of $960,000.
3. Income — The calculation above also assumed that my wife income is staying at the same level, however, this is probably not going to be the case. For example, my wife is currently working part-time. If she’s the only earner, she’ll most likely go back to work full-time and double her income.
4. Return on investment — 5% is a fair number. This amount should be adjusted down if the living spouse is risk-advert, or not savvy about investing. Likewise, the amount could be adjusted upward — however, I wouldn’t push the amount above 7%. For example, at 7% return on investment, my wife would only need $686,000 instead of $960,000.
   
5. Taxes — 25% is a fair number. However this could be adjusted up or down depending on the income level. For example, at 20% tax rate, my wife would only need $900,000 instead of $960,000.

As an example, assuming $2,000 expense, return on investment of 7%, and 20% tax rate, my wife would only need $430,000. As you can see, even small changes can greatly impact the calculation.

Opportunity Cost

Following my own advice, I already got a few competitive quotes through InsureMe and NetQuote. One of the quotes came from a broker who is free to work with any insurance company. At this point, I think I’ll be working with him for the policies since he can run our information through several companies and find the best deal for us.

Based on the quotes I received we will be spending about $100 per month on the two 30-year term life policies. I recently did an article on opportunity cost, and our opportunity cost for these two policies over 30 years is approximately $121,000 — not bad for the coverage we are getting.

Other articles in this series:

• How Much Life Insurance Do I Need?
• Should I Buy Whole Life Insurance?
• Is Term Life Insurance Right For Me?
• Making Progress Toward Buying Our Life Insurance

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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