How Much Life Insurance? - Enhanced Methods

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How Much Life Insurance? - Advanced Methods

The following three approaches to life insurance needs (annuity method, capital preservation, and preservation of purchasing power) are similar in their basic approach. The latter two methods use the annuity method as the starting point and factor in additional life insurance to preserve the capital in terms of nominal and real dollars. These three approaches address the issue of the family's changing needs over the years. There are three basic life stages in a family’s existence:

1) The first is the period starting with the current age of the surviving spouse and ending with the age of the surviving spouse when the youngest child goes to college. Presumably, this is the period when the family living expenses would be higher as the children are living at home.
2) The second stage is the period beginning with the age of the surviving spouse when the youngest child goes to college and ending with the expected retirement date of the surviving spouse (even if the surviving spouse has no employment earnings). During this time, the surviving spouse maintains the existing household while the children are in college. If the surviving spouse were employed, the family expenses would still be high although not as high as when the children were living at home.
3) The final stage is the period of the surviving spouse’s retirement. This begins with the retirement date and ends at the surviving spouse’s life expectancy. In theory, the expenses are lower during this phase because the mortgage is paid off, the children are hopefully out of the house and gainfully employed, and taxes may be lower.

In addition to the family life stages, these approaches to life insurance needs assume that all debts are paid at death and that the children’s education needs are completely funded. If the surviving spouse has employment earnings and will continue to work upon the death of the first spouse, then those earnings reduce the retirement needs correspondingly. If the surviving will cease to work at the death of the first spouse, then the needs will be higher.

Instead of going through an example, we invite you to download a copy of our Insurance Needs Analysis software. You can then enter your own information and calculate the required life insurance needs for your particular scenario.

Once the annuity approach needs are calculated, the remaining two approaches are straightforward. The annuity approach assumes that all the assumptions in the projection materialize as expected and at the life expectancy of the surviving spouse, the remaining funds are zero. Therefore, you have to die on your birthday according to the life expectancy tables, earn the assumed rate of return and spend exactly what was anticipated. Not likely unless you typically invest in South Florida Gold Mining Companies. Therefore, you need to factor in some "cushion" into your numbers.

The Capital Preservation Method assumes that if you receive an insurance settlement and all assumptions materialize as expected (see previous paragraph), then at the end of the surviving spouse’s life expectancy, the exact amount of the insurance needs will remain. For example, if the settlement was $500,000 in 1997, at the end of the surviving spouse’s life, the same $500,000 would remain and the children would be happy.

The Preservation of Purchasing Power Method takes the analysis one step further. The value of the $500,000 in the previous paragraph changes over time primarily due to inflation. Assuming an annual inflation rate of 3% and a life expectancy of 40 years, the present value of $500,000 forty years from now is $153,278. If we wanted to "preserve" the purchasing power of a $500,000 settlement, the amount forty years from now would be higher. In this example, the future value of $500,000 over forty years at an annual inflation rate of 3% would be $1,631,019. In essence, your kids would be happier using this approach than any of the other approaches, and of course, you would spend more money on premiums now.