Revisiting The Life Insurance Rule of Thumb
After a decade of being in the shadows of the markets, life insurance is back at center stage. This makes it a good time to revisit the life insurance rule of thumb, or how to answer when a client asks how much life insurance he or she should have.
Its a fact that the events of the past two years have made addressing asset protection a fairly easy process with clients, young and old. Most individuals have come to appreciate the importance of preparing for an untimely death. In the wake of September 11, hardly a week went by without a media story on the importance of having risk management products such as life insurance.
A June 2002 Harris Poll commissioned by Northwestern Mutual shows that nearly one in three Americans have an increased need to talk with a financial professional. This is not a surprise considering the tribulations weve experienced with the economy.
With regards to life insurance, 31% of Americans purchased more coverage following 9-11 even though 80% already had life insurance on their own, through an employer or both.
Heres the rub: Many Americans are still underinsured. Moreover, the chances are, they dont even know it. The majority of individuals with household incomes of at least $75,000 (those more prone to plan) have less than $250,000 of coverage: 76% own permanent insurance and 61% own term. Yet, 83% believe they have enough.
Whats at issue here is the seemingly never-ending confusion over the rule of thumb. Where some say its five to 10 times earnings, others offer their own calculations.
Employers typically offer life insurance benefits in the amount of two times income–a significantly insufficient number for most people. Remember, life insurance must cover more than just day-to-day expenses and, in some cases, for more than just a few years.
Another very simplistic approach–also misleading–is based on annualizing all monthly expenses, multiplying that by the number of years survivors will need financial support, and subtracting any existing savings and investments. It is a calculation that assumes the nest egg will run out in a set number of years and that the family will eventually make up the breadwinners lost income. However, this scenario does not take into account the impact of inflation, nor does it fully capture future expenses such as college education or retirement for the spouse.
The United States Department of Justice, in distributing the Victims Relief Fund to the surviving family members of those lost on September 11, outlines a process to determine the economic loss. Their tables (www.usdoj.govvictimcompensation) enumerate settlements that ranged from 4 times income to as much as 50 times current annual income for individuals of various ages and income levels. For a 40-year-old individual with $100,000 in annual income, the payout was calculated at 18 times income.
LIMRA International uses the USDOJ data as a starting point. As a rule of thumb, start with the average multiple of income from the DOJ figures–in the range of 25 times income–then deduct the value of any government benefits, existing investments or other sources of income.