When 'Rules of Thumb' for Life Insurance Don't Work

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Ughhhh. Life insurance isn’t exactly a fun topic to talk about, is it? Yet, it is essential coverage for many families who want to protect the future earnings of one or both spouses.

Does Life Insurance Deserve a Place in Your Retirement Portfolio?

There used to be a rule of thumb among insurance agents that your death benefit should be equal to a multiple of seven to 10 times your annual pre-tax income. Here are a three scenarios where this rule of thumb is not helpful:

1. Stay-At-Home Parents

If you’re a stay-at-home parent, you’re not receiving financial compensation for hard work at home. Following the rule of thumb, you should have no life insurance coverage, because your financial earnings are zero. However, your spouse would need to secure childcare and may require other professional services if you unexpectedly die. Examples of these services include housekeeping, laundry, meal delivery or prep services and home maintenance.

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Consider the total cost to provide all these services on an annual basis, and multiply by the number of years that your children will require additional financial support. A stay-at-home parent with two toddlers will require more life insurance than a parent with two teenagers who will be out of the house in a few years.

2. Families With Young Kids

Budgeting as a young family is tough. You are steadily building work experience and have the added expenses of childcare and schooling. You may need MORE than 10 times your salary. Think about future expenses and how long it will take you to amass enough wealth to accommodate your family’s needs.

I’ll use my family as an example. We have a mortgage, and our three boys are ages 3, 5 and 8. Full-time childcare costs for our younger boys average $20,000 annually, and private grade school tuition for our eldest son runs $5,000 annually (excluding after-care program costs). We plan to send all three boys to Catholic high school, which runs about $15,000 annually per child. That figure is not even factoring in the costs of clothes, activities and food for our growing boys. College is incredibly expensive and must be considered as well.

After carefully reviewing these expenses and our future earnings, we decided that 10 times annual salary isn’t nearly enough to fund our family’s lifestyle. My husband and I each have coverage closer to 20 times annual salary.

3. Those Nearing Retirement

For term life insurance, especially, age is not on your side. Premiums increase substantially in your 50s and 60s. Perhaps you’re within a few years of retirement and you’ve amassed enough wealth to live comfortably. Self-insuring, or using existing assets in lieu of an outside insurance policy, may make sense.

According to the Merriam-Webster, insurance is “a means of guaranteeing protection or safety.”

In other words, when you purchase an insurance policy, you’re transferring risk from yourself to an outside third party. In exchange for that transfer of risk, you agree to pay premiums. When you stop paying premiums on a term life insurance policy or disability policy, your insurance coverage ends. Whole life or variable life policies usually require significant premium payments in the early years of a policy with the hope that premiums can stop in later years and the policy remains active or “in force.”

Two-Thirds of Americans Have Inadequate Insurance. I Was One of Them.

A Look at the Different Insurance Options

Now that you have a framework for the amount of life insurance coverage you may need, let’s turn to the types of insurance policies.

Term Insurance

For young families, especially, term life insurance is my typical recommendation. It is the most inexpensive type of policy and akin to renting versus buying a home. You only have coverage if you continue to pay the premiums. Some term life policies have an increasing premium, because they assume your earnings will steadily increase. Other term policies are fixed: Your premium will remain the same each year for the duration of the policy. Under the fixed-policy, premiums are higher if you have a longer term. For instance, your annual premium may be $1,000 for a 15-year level term but $1,300 for a 20-year level term.

Large employers typically over basic life insurance coverage equal to one times your annual salary at no cost to you. They also may offer supplemental group policies (i.e., up to a $500,000 death benefit). The supplemental group policies vary significantly by employer.

One of my clients is a federal agent. She was paying over $500 annually for $500,000 of coverage as a government employee. We looked at individual term quotes and found a policy with a lower premium (about $450) for $1 million of coverage. She could get double the coverage for less cost by using an outside, individual policy! Her employer penalized young, healthy employees in their group life insurance policy. If she were 20 years older, her employer-provided group policy may have been the better deal.

Whole Life

Compared to term insurance, whole life policies offer valuable long-term protection. When the whole-life policy is “paid up,” you are no longer required to make premium payments. In the meantime, cash value builds in the policy. You can take loans against the cash value, but be wary of high interest rates.

Here’s another personal example. I started working with very wealthy families in 2006 and found myself collaborating with insurance agents on whole life policies for select clients. Many of these families were using life insurance to pass more wealth to heirs — income tax free.

I became engrossed in this world of estate planning and tax mitigation and pursued a whole life policy for myself. My annual premium was $3,000 for $500,000 of death benefit. Much of the premium in the early years paid the agent commission and internal costs. Couple that with mediocre dividends from the low interest rate environment, and I was left with very little cash value.

About 10 years after starting this policy, I decided it was not worthwhile anymore. My accumulated premium payments were slightly more than the cash value of the policy. I could take the policy “paid up” and reduce the death benefit to about $130,000; alternatively, I could remove the cash value. I choose the latter. Paying off my car loan and purchasing a new $1 million term life policy ($450 annual premium) provided better bang for the buck.

As you can see, insurance isn’t cut and dried. Choosing an appropriate insurance policy can be difficult on your own. A Certified Financial Planner™ who specializes in comprehensive financial planning can help you evaluate and secure the life insurance policy best suited to your needs. Even better, consider working with a fiduciary fee-only planner who doesn’t work on commission.

Beware of These Often-Overlooked Insurance Gaps

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Deborah L. Meyer, CFP®, CPA/PFS, CEPA and AFCPE® Member, is the award-winning author of Redefining Family Wealth: A Parent’s Guide to Purposeful Living. Deb is the CEO of WorthyNest®, a fee-only, fiduciary wealth management firm that helps Christian parents and Christian entrepreneurs across the U.S. integrate faith and family into financial decision-making. She also provides accounting, exit planning and tax strategies to family-owned businesses through SV CPA Services.