How Much Life Insurance Do You Need?
by Mark Cybulski
It's an age-old question with myriad answers: "How much life insurance do l need?"
Some financial advisors will tell you to multiply your annual income by seven. Others will tell you to buy only enough life insurance to replace the income you are expected to make between now and retirement. Some may recommend that you buy only enough life insurance to cover your present debts.
While you probably can do all of those calculations in a minute, they won't give you the right answer. Simply put, calculating your life insurance needs takes homework. It requires you to do an inventory of all of your finances, and to think long and hard about how your beneficiaries would maintain their lifestyles without you. You also must consider inflation and, if you have children, future college education costs.
"It sounds crass, but we are money machines."
"It sounds crass, but we are money machines," says Richard Weber, vice president of strategic marketing for Financial Profiles Inc. of Carlsbad, Calif., which produces and sells financial planning software to life insurers such as John Hancock, MassMutual, MetLife, and the MONY Group. "Anyone who works for a living and who has dependents who derive benefits from that wage is a cash resource."
What Not To Do
What's the wrong way to calculate how much life insurance you need? Here are some common but misguided methods.
Bad way No. l: Multiply your annual salary by seven or eight. This is perhaps the laziest way to calculate how much life insurance coverage you should buy. "This way is appealing because it's so simple, but it overlooks so many individual factors," Weber says. "It's not a very satisfying way of finding out what you should have."
Bad way No. 2: Calculate your "human life value.
" This method gives you the income you will earn from your present age until your retirement age, assuming a rate of interest that represents salary increases throughout that period. The problem here is that it does not take into account what your beneficiary's specific needs will be. You also end up with a figure that requires you to buy a huge amount of life insurance, possibly more than you may need. "There's all sorts of land mines in this," says Michael Snowdon, an instructor at the College of Financial Planning in Denver. "When you calculate this way, you're working with broad brush strokes."
Bad way No. 3: Cover your debts.
 This entails buying only enough life insurance to cover debts such as your mortgage, student' loan bills, or outstanding car notes. The problem with this method is it does not consider any future debts or needs, such as child care or college education costs.
A Classic Formula
A must-know: the equation for the future value of money

Calculating your life insurance needs will require two equations that you may have picked up in Finance 101: the future and present values of money equations.

The future value of money equation tells you how much your money will be worth in a given number of years while earning a given rate of interest. This equation is essential if you are calculating how much money you'll need in the future because of inflation, or what your death benefit will be if you choose to invest the money at a given interest rate.

The present value of money equation tells you what your money is worth before it has been invested for a given number of years at a given rate of interest. This is important if you have an amount of money that you need to have in the future, and you need to know how much life insurance coverage you should buy now to invest it at a given rate of interest at a given number of years.

If this sounds complex to you, don't fret. As long as you have a calculator (preferably a financial calculator, which is used by accountants and finance professionals), these equations are no sweat.

Here's how the future value of money equation works: Say that average college education costs are $20,000 annually for a private four-year institution, and you want to figure out how much it will cost in four years if college costs keep going up 5 percent per year. You would multiply 20,000 by 1.05 (1 represents the present cost, and .05 is 5 percent inflation) four times (or 1.05 to the fourth power).

So your equation would be this:

20,000 x (1.05)4
or
20,000 x (1.05)(1.05)(1.05)
(1.05)
The answer is $24,310.13.
Many experts say the best way to pinpoint a smart life insurance figure is through a needs analysis, which can be broken down into a simple formula: Short-term needs + long-term needs - resources = how much life insurance you need. Snowdon says this method is "probably the most accurate approach in what is an inaccurate and imprecise science."

Experts advise that you do an analysis at least once every three years, or whenever you have had a major life change. For example, if you have a new baby, you have to recalculate college education needs and child-care costs. If you own a home, a mortgage is likely your biggest financial burden. Because your mortgage balance decreases with each payment, it's important to include those revised figures in your calculations. "Some of your needs may decrease, some of your needs may never go away," notes John Campbell, director of training and professional development for John Hancock Financial Services.

Five steps to a needs analysis

Step 1
Add up all of your short-term needs. These can be placed into three categories: final expenses; outstanding debts; and emergency expenses. Among final expenses are medical, hospital, and funeral expenses, attorney or executor fees, probate court costs (if you do not have a will), and any outstanding taxes that would need to be paid if you died. Among outstanding debts are credit card balances, auto loans, college loans, and all other outstanding bills. Emergency expenses should include a cash reserve for medical emergencies and repairs to your home or car.

Calculating final and emergency expenses can be complicated, because you don't have a crystal ball that tells you how much your medical or hospital expenses will be, or if you even will have any. But Weber recommends that you allocate 50 percent of the higher wage earner's salary for the final expenses part of the calculation, and three to six months worth of living expenses as your emergency expenses.
Step 2
Next, add up your long-term debts, which include your mortgage and college tuition (the latter two only if you have children). For your allocation to your mortgage, put down the balance.

Calculating an education fund is tricky because you have no idea where your children will be going to college. Perhaps the best method is to use the present average college cost in the United States and the number of years away your children are from entering college. The average college cost for the 1999-2000 school year were $8.086 annually for a public four-year institution, and $21,339 annually for a private, four-year institution, according to The College Board.

Vance Grant, an education statistics specialist with the U.S. Department of Education, says that college costs traditionally have been rising at about 5 percent annually, so you need to figure out what the cost will be when your child goes to college. (To calculate what costs will be in the future, see the sidebar regarding the future value of money equation. Also be sure to calculate what the entire education will cost while taking into account the increased costs each year.)

Step 3
 Next, calculate family maintenance expenses. These include such necessities as child care, food, clothing, utility bills, entertainment, travel, and transportation. Calculate this figure based on a year's worth of expenses, then multiply that times the number of years you want to provide this income.

Once you've done that, add your short- and long-term debts and your family maintenance expenses.

Step 4
 Now that you've tallied all of your income needs, figure out what resources you have to meet them. To do this, add all available savings, stocks, bonds, mutual fiends, existing life insurance (such as group life through your employer), and Social Security. You and your spouse can find out how much you'll get through the Social Security Administration (SSA) by visiting the SSA's Web site, where you can get an estimate of how much you should have in Social Security benefits. Also add your present salary, and assume 5 percent compounded interest each year if you expect salary increases over time.

Weber notes that it's important to count only liquid assets (those that could be quickly converted to cash) among your resources. You shouldn't count items such as your home or automobile, because selling them for cash when you're gone would mean changing your family's lifestyle.
Step 5
Subtract your resources from your total expenses. The figure you get should represent the amount of life insurance coverage you should buy.
"Many people will look at the final figure and say, "I can't do that."
Don't be daunted
Snowdon says the final figure that shows how much life insurance a person needs can be quite alarming. But if you end up with an Astronomical figure that requires a premium that is too high, he recommends you go through the analysis again and select areas for which you think you can allocate less money. "Many people will look at the final figure and say, 'I can't do that,"' Snowdon says. "You have to look at it, figure out which is the most crucial, start making adjustments, and go from there."
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