How much life insurance do you need? $50,000? 5 million? To answer this question, we need to look at ‘why’ you’re considering buying life insurance.
Why? Standard of Living
For many, the answer to ‘why’ is that we want our financial dependents – our family – to maintain their standard of living should we die. We don’t want anyone getting rich, but we don’t want anyone going broke either. We want your family to simply maintain their standard of living should you die. We want them to live in the same home, drive the same car, eat the same brand of groceries.
That standard of living – the mortgage, the bills, the groceries, the car payment – has a cost. That cost is currently paid through your paycheque, your income.
You are Your Paycheque
This is a key component to understanding how much life insurance we need. We currently maintain our standard of living using our paycheque. If we die, from a financial perspective (not an emotional perspective – that’s a different subject) we lose our paycheque.
In fact, for most of us, our largest financial asset we have is our income over the years. And it’s that asset that we lose if we die. We don’t lose our mortgage, or our bills, or our savings for children’s education. We lose our paycheque for a period of years. Insurance is designed to replace a financial loss, and this approach focuses on the financial loss when we die – our paycheque.
If we use life insurance to provide a replacement paycheque should we die, then our dependents can continue to maintain their existing standard of living using this replacement paycheque. We’ve then done the job we set out to do. The life insurance calculator below uses this premise to answer the questions ‘how much life insurance do I need’.
Life Insurance Calculator
The following calculator calculates how much lump sum insurance you would need to provide a replacement income over a period of time. You can think of the capital as being the life insurance proceeds put into a savings account, and then your replacement income is withdrawn and placed into a chequing account each year. The money in the chequing account is what your dependents then live on for the year – so nobody gets rich but they maintain their standard of living. At the end of the time period, the money is completely gone – the life insurance proceeds have gone to 0 and nobody got rich, they merely maintained their standard of living.
The following points may assist:
- Percentage of Income: many of us will assume that if we die, our dependents don’t need 100% of our paycheque in order to maintain their standard of living. A common rule of thumb is to assume 80% of your income is sufficient for 1 income households and 60% is sufficient for 2 income households.
- Number of years to replace income: This is how long we would assume we need to replace the income for. I recommend you try different values for this input in order to get a range of values. On the top end you would use the number of years until you expect to retire (to completely replace your income should you die tomorrow). On the lower end, you may use the number of years you expect it will take your children to become financially self sufficient. If you are 40 years old and you’re youngest child is 5, you might try values of 25 years (until you would be 65) and 15 years (assuming that your 5 year old will be financailly independent at age 20).
- Would your beneficiaries use this tactic with the insurance proceeds should you die? Probably not. At that time they would determine how best to use the insurance proceeds. The calculator is designed to show us a reasonable range of insurance to make sure we don’t have too much or too little. It doesn’t address how to use the insurance proceeds, which would normally be determined after the fact.
- The use of future assumptions in these types of calculations means there is no perfect answer to how much life insurance you need. To counter this, you should try different inputs for the calculator in order to get a range of values that you should consider. Within that range you can then apply other personal considerations as to whether you prefer to be on the top or bottom end of that range.
- This calculator works best for income earners with financial dependents. If your needs are different this calculator may not apply. Please feel welcome to contact us to speak to a broker who can assist you with your specific needs.
- Find the numbers to be high? Many of us should have more coverage than we expect. It’s not that we need such a large initial amount – it’s that we need an income over such a long period of time. Producing a replacement paycheque over 10,20, or 30 years can take more of a lump sum than most people expect.
Note: The calculator is dynamic. Simply move between the fields using your mouse or the tab button in order to update the table automatically.
Year Remaining Insurance Proceeds Beginning of Year Replacement Paycheque Interest Earned on Insurance Proceeds Remaining Insurance End of Year 1 7,000.00 1,000.00 180.00 6,180.00 2 6,180.00 1,030.00 154.50 5,304.50 3 5,304.50 1,060.90 127.31 4,370.91 4 4,370.91 1,092.73 98.35 3,376.53 5 3,376.53 1,125.51 67.53 2,318.55 6 2,318.55 1,159.27 34.78 1,194.05 7 1,194.05 1,194.05 0.00 0.00