Boston — If there is any financial planning decision most people would rather avoid, it is probably figuring out how much life insurance to buy. In many cases, life insurance needs are figured backward; that is, people decide how much they can afford to spend on annual premiums, then they buy that much coverage. Needs should come first, financial planners say.
In determining needs, two general questions should be answered: How much money will a breadwinner's heirs need to maintain the family's standard of living and pay any future education expenses? How much of this money will be supplied from non-insurance sources such as savings, annuities, social security, and a spouse's potential earning power? Subtract the answer to the second question from the first, and you have the insurance that will be needed.
This is the closest many financial planners will come to establishing a rule of thumb for life insurance needs. Sometimes, when pressed, one planner will say a married wage earner should have six or seven times his or her annual income in insurance coverage. Another might say four or five times; and another might say 10 times.
But the problem with all these multipliers is that they pigeonhole people. Take two families living in the same town, for instance. In both cases, the parents are in their mid-30s, they each have three children, and the fathers earn between $40,000 and $45,000. It would seem their insurance needs are the same. Yet there can be differences.
In one case, the mother may have a master's degree, have previous professional experience, and would have little trouble reentering the work force at a starting salary of $20,000 or so. This family may plan to send at least two of their children to private colleges and like to travel on vacations.
In the other family, the mother may have little or no college experience and little work experience. She likely would have to start work at a lower salary. At the same time, however, this family has decided on public colleges for their children and have confined themselves to modest vacations near home while they saved a greater share of their income. If the savings are large enough, the interest from it may itself go a long way toward supplementing family income.
So financial habits and goals play as much a part in determining insurance needs as immediate income protection. So do the number of people working in the family. If both parents work, it should be asked why the second income is needed. If it is for a future need, like college, there should be enough insurance to pay for expected college costs, while insurance may not be needed to replace the second income.
It should also be remembered that money works, too. So you do not need to estimate the number of years that income protection is needed and buy insurance to cover all those years. A $100,000 insurance payment, invested wisely, could produce over $10,000 of annual income, at current rates. This, added to social security survivors' benefits and the spouse's earning potential, could provide a fully adequate income.
Social security benefits are determined by the age of the parent's age at death and on earning history. A social security office can tell you the maximum monthly benefit per survivor and the maximum monthly benefit, which you can then multiply by 12 to get annual social security income. Children are eligible until they are 18, and if a surviving parent earns less than $4,440 a year and has any children under 16, that parent is also eligible.
Beyond immediate income needs, you may want additional protection for things like college expenses, additional child care, mortgage protection (although many mortgage lenders usually build insurance payments into the monthly payments),and funeral and estate costs.
Using this method of subtracting all expected income from expenses, you may find you need less insurance than you think. Like the entire financial plan, however, this process should be repeated every year or so to take inflation into account. This is particularly true of college, where rising tuition costs can throw an entire financial and insurance plan completely out of whack every few years. Other changes may also affect insurance needs: A family's size may change; an employer's group life insurance coverage may increase; or an investment may pay off.