Stephen A. Rossi, BridgeTower Media Newswires
Purchasing life insurance is an important decision for many people. Available policies range from term life and endowment contracts to whole life, universal life, and even variable universal life insurance products. The wrappers may differ, but each involves paying regular periodic premiums to an insurance company, in exchange for a promised payout upon one or more person’s death. Regardless of the type of policy purchased or the terms under which it pays a death benefit, determining an appropriate amount of life insurance coverage can be challenging. What follows are a few of the more common approaches to making this decision.
The Capital Retention method for determining an appropriate amount of life insurance is most simplistic. It considers the net assets of an individual upon death and aims to supplement those assets with a death benefit, such that the interest earned on the combination of the two (i.e., presumably invested in U.S. Treasury securities) is sufficient to support the family and/or other dependents left behind. As its name implies, this method is designed to retain capital, and is in line with the notion that you should only spend the income generated by your investable assets, while never touching principal. The problem with this approach is that it doesn’t consider inflation, and so while capital itself may be retained, its purchasing power will undoubtedly fade over time.
Another strategy for determining the appropriate amount of life insurance deals with a concept called programming. Programming (think planning) is a means of assessing an individual’s present as well as future needs and can be implemented using the Human Life Value method or the Financial Needs Analysis method.
According to the Human Life Value method, the income of the insured, including raises, is projected to the end of their work life. Most often, cash flow is adjusted downward to account for what the individual would have consumed or paid in taxes for the period, and a future value of net cash flow – let’s call it the future value of the family’s share of earnings – is computed. This future value is then discounted back to the present at a discount rate matching some assumed rate of inflation (expressed as an annual percentage). Theoretically, the present value of the family’s expected share of the individual’s future earnings becomes the value of the individual’s human life (admittedly, a morbid concept), and, accordingly, the appropriate amount of life insurance coverage to purchase.
By way of example, an individual who earns $60,000 a year with a combined Federal and State income tax rate of 15% would take home $51,000 in after-tax earnings (i.e., $60,000 x 0.85). Assuming he or she personally consumed 10% of this after-tax amount each year (i.e., $5,100), net annual cash flow in year 1 – let’s call it the family’s expected share of earnings – would be $45,900 (i.e., $51,000 - $5,100). Assuming the individual was 56 years old with 20 years left to work, and that their annual raises were expected to be 3% per year, we could calculate a future value of the family’s expected share of earnings by using $45,900 as our present value and compounding this amount by 3% annually over the next 20 years. What we’d arrive at is a value of $1,437,167 as the total future value of the family’s share of the individual’s expected earnings. We’d then convert this value to a Human Life Value by discounting it back to the present using an annual inflation rate – let’s say 3.5% - to arrive at the appropriate amount of life insurance coverage to purchase, which in this case is $722,271 (round up to $750,000).
The Human Life Value method of calculating the appropriate amount of life insurance goes one step beyond the Capital Retention method, in that it builds an inflation expectation into the need. What it doesn’t directly address is the immediate payoff of any debt that may exist at the time of the individual’s death. The assumption is that any existing debt would be satisfied over time, using the cash flow already considered in the analysis. It also assumes that all employment-related cash flows cease at the end of the individual’s work life, which may leave little, if any, wealth left to be passed to the next generation.
The Financial Needs Analysis method for calculating an appropriate amount of life insurance goes even further than the Capital Retention and Human Life methods. It not only seeks to preserve purchasing power by building in inflation adjustments for different pockets of need (i.e., life income, education, dependent medical expense, etc.), but also provides for the payoff of existing debt upon the insured’s death, to minimize the need for ongoing cash flow from that point forward. The Financial Needs Analysis approach employs many of the same future value and present value calculations as the Human Life Value methodology, but it tends to be more comprehensive in nature. It can be designed to mirror the characteristics of an annuity – that is, that the entire death benefit and all interest that accrues thereon is ultimately consumed by the policy’s designated beneficiaries – or it can be approached to provide annuity income and capital preservation features, to provide for the ongoing needs of future generations on an inflation-adjusted basis as well.
Price is often a limiting factor, in terms of how much life insurance one can afford to purchase. That said, understanding the basics of calculating an appropriate amount of life insurance can help guide you with that decision. Whether it’s the basic Capital Retention approach to generate income and retain principal (but not purchasing power), the Human Life Value approach to preserve purchasing power and provide income for the remainder of one’s potential work life, or the Financial Needs Analysis approach, which can provide the most comprehensive coverage of all (including payoffs of existing debt, the generation of income, preservation of purchasing power and preservation of capital), having some amount of life insurance is better than having none. A trained financial planning professional can help you with this decision because, after all, your life insurance may be someone else’s life assurance.
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Stephen A. Rossi is senior vice president and senior equity strategist at Canandaigua National Bank & Trust Co.
