(Are you attending the Real Estate & Entrepreneurship Conference for Physicians on September 26-28, 2024 in Dallas, Texas? If so, send me a message so we can meet up. I would love to meet you in person.)
Purchasing life insurance is a very misunderstood transaction. The buyer doesn’t know how much life insurance his family will need, and the seller wants to sell as much insurance to their client as possible to make the biggest commission.
Many life insurance agents take the lazy way out by offering to sell the amount of life insurance that will replace your income, or the maximum amount of insurance that they think you can afford.
The problem with both approaches is they are often selling you the wrong amount of insurance. If you buy too much protection, you are wasting money in premiums. If you buy too little protection, you are putting your family at risk. If you buy the wrong type of protection, you might be doing both. The life insurance agent is not the best person to ask for advice on the amount of life insurance to purchase.
During my working years the partners met with our accountant and attorney annually. Every year our attorney told me I didn’t have enough life insurance. I asked why he thought that. His answer was that his other clients with my income have more insurance than I had, so I should get more. He had no idea what my personal financial situation was, and yet he felt he could confidently tell me how much life insurance I needed.
Our family only lived on half of our income and that alone, by his standards, should have cut my insurance needs in half. We also had no debt and a substantial amount of real estate income he didn’t know about. My situation was likely not the same as his “other” clients.
Every life insurance purchaser’s financial situation is different and therefore they each have differing financial needs upon death. Therefore, everyone must purchase an amount of insurance that will meet their specific needs. You should NEVER be sold an average amount of insurance based on the average need of others sharing your income level.
Consider the following steps to calculate the right amount of life insurance for your family.
Establish what your family’s budget would be if you were gone
This is the first and most important step in determining how much life insurance your family needs. Almost every agent skips this step because it is too much work. The easy answer is just to replace your income.
The problem with the agent’s method is insurance is not used to replace your income; it is used to support your family when you can’t. Unless you know what your family needs in the way of support, you don’t know how much insurance you need to purchase.
There is a great difference between the needs of a family with three small children and a $1.8M mortgage, and the needs of a family with no mortgage and no children. Yet if these two families had the same income, the agent would likely recommend the same amount of life insurance coverage.
Decide what the children need
Your children will need to be taken care of until they are out of the nest. Since young children have no way of earning the money to supply their needs, you must decide if the money from your life insurance policy will provide for their basic care, or if your surviving spouse will handle it. Do you wish to cover their college education, or will each child pay for their own education? If you want to pay for you kids’ college education, do they have a fully funded 529 accounts, or have you not begun saving for their college education?
Understanding what you wish the kids to have as your legacy is crucial in the decision of how much life insurance you need.
Decide what your spouse needs
Is your plan to set your spouse up for life so they never have to work again? Or should you provide enough to get them through the first few years until they can get accustomed to the new life without you? Do you expect your spouse to remarry a few years after your death, at which time they will have financial help supporting the family? Does your spouse have a good-paying job and not need any financial support if you are gone?
I recently coached a couple who consisted of a stay-at-home mom and a high-income dad. They had a few million saved, passive income coming in, and the kids already had their college costs covered.
The stay-at-home mom was sold a life insurance package with several million dollars in coverage which included a small universal life policy. When we looked at their finances and family needs if she were to die, there would be no financial hardships in the family. She did not need any life insurance.
The husband, on the other hand, was providing a great amount of financial support to the family and his support would be very much missed if he died. He had less life insurance than his wife! He was underinsured and she was over insured. If she died, they would receive a lot of money they don’t need. If he died, they would face economic hardship and significant changes to their lifestyle would need to occur.
Their life insurance agent did not address these issues when selling them insurance.
Look closely at what you already have
The current assets you have already set aside, like savings, investments, and retirement accounts must also be considered in deciding the amount of life insurance needed.
If, after making a budget and looking at the needs of your spouse and children, you calculated your family would need a nest egg of $6M if you died today, and you already have $2M in investments, then your shortfall is only $4M. Therefore, you should only buy $4M of life insurance, the amount that would be required to take your family up to the $6M needed to survive well without you.
Also, reduce your needs by any amount of passive income you have. In my case, the income from my rental units decreases my life insurance needs.
Project your future needs
This is the final and extremely important step. If you are saving a substantial amount of money, then take its future value into account. As your investments grow, and your debts decrease, your need for life insurance falls.
If you calculate an insurance need of $6M, you will not need this fixed amount your entire life. Your assets will continue to grow. Your mortgage will shrink. Your kids will be out of the nest at some point and no longer need your support.
With all these factors, your life insurance needs drop a little every year. At some point the need will fall to zero as you will have enough assets saved to cover all the family needs. At that point you will no longer need any life insurance.
For this reason, it is important that your life insurance plan accounts for having less insurance as time goes by. Instead of buying a $6M, 30-year level term policy, you will likely be better served with a policy ladder. The ladder might look like this:
$2M of 30-year level term.
$2M of 20-year level term.
$2M of 10-year level term.
If you acquire this three-policy plan, you will be insured for $6M for the first ten years, $4M for years 11-20, and $2M for years 21-30. After thirty years you are projected to be financially secure and self-insured, with no further life insurance needed.
Be sure your life insurance agent earns their commission. Don’t let them treat you as an “average” customer. Before you meet them for the first time, you should already have an idea of the amount of insurance you need. And please don’t let them talk you into using your life insurance as any type of investment vehicle. Investments are designed to provide for you while you are alive. Life insurance is designed to support your family if you die. Those goals do not mix well.
Learn more in my articles on Calculating the Right Amount of Life Insurance and How I Learned About Life Insurance the Hard Way, or in my book on Starting Your Practice/Career Right.
