RPF0178-Life_Insurance_Needs_Analysis
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00:01:03.300 | Today we continue our discussion of life insurance.
00:01:07.300 | And I'm going to teach you how to calculate a simple needs analysis for life insurance.
00:01:14.300 | This will help you to figure out on the back of a napkin exactly how much life insurance coverage you should have for your financial plan.
00:01:23.300 | ♪
00:01:39.300 | Welcome to the Radical Personal Finance Podcast.
00:01:41.300 | My name is Joshua Sheets and I'm your host.
00:01:43.300 | And yes, we continue today with the long-anticipated discussion of life insurance.
00:01:50.300 | But I've got to do it systematically.
00:01:52.300 | I promise, I promise, as many of you requested, I will cover the debates that happen in the life insurance industry.
00:01:57.300 | But don't you think first we should start with a simple answer to how much and then handle the debates?
00:02:04.300 | ♪
00:02:11.300 | It's very important for you to approach financial planning questions in a systematic manner.
00:02:16.300 | Because if you approach them in a systematic manner with a background of information and a background of insight
00:02:21.300 | and just a framework for how to approach the planning question, you will quickly be able to understand what people should do in a given set of circumstances.
00:02:32.300 | Last week's episode, last Wednesday, I released episode 173, and that was the basis of life insurance.
00:02:42.300 | Basically, thinking through what are the uses of life insurance from a personal perspective for individuals and their families.
00:02:49.300 | We'll deal with the business planning aspects in future episodes.
00:02:54.300 | But one of the pieces of feedback that I got from several commenters on the show, they said, "I want to get into whole life insurance versus term life insurance.
00:03:00.300 | Come on. Let's talk about whole life insurance and term life insurance.
00:03:03.300 | I want to talk about whole life insurance and term life insurance."
00:03:06.300 | And this is exactly where many people want to go.
00:03:10.300 | This is where much of the financial advice, personal financial advice industry goes.
00:03:16.300 | Let's talk about product.
00:03:18.300 | What's the right kind of product?
00:03:20.300 | But stay with me.
00:03:21.300 | We'll eventually get there.
00:03:23.300 | But if you start with actually what's the need that I'm trying to solve and you fix that, the product is usually self-evident.
00:03:32.300 | If you actually start with a needs analysis approach, what you will find is that the vast majority of families who need life insurance cannot afford to own the full amount of life insurance that they need with a permanent life insurance product.
00:03:47.300 | And that's why term insurance is a tremendously powerful life insurance product because it's the cheapest way for you to buy a lot of insurance coverage for just a few bucks a month.
00:04:01.300 | But if you never start by actually sitting down and calculating how much life insurance you need and you start by saying, "Let me understand the intricacies of any one particular contract," you might run the mistake of buying the wrong kind of contract that doesn't actually solve your need.
00:04:22.300 | Interestingly though, that's exactly the problem that wasn't solved by many insurance agents and many insurance companies, which ultimately led to the decimation of the whole life insurance industry.
00:04:38.300 | Because what happened is – probably the best example is a little bit anecdotal, but one of the men who has had a bigger influence on the insurance industry in the United States than anybody else is a man named Art Williams, A.L. Williams, who founded a life insurance company.
00:04:54.300 | Later, it's now known as Primerica, the company that was – he sold it. It was – I think it's owned by Bank of America now.
00:05:01.300 | Maybe they sold it. I can't remember. Point being that his father had purchased some life insurance but had purchased a small whole life insurance policy and then his father died and there wasn't enough money left for the family.
00:05:17.300 | The same thing – A.L. Williams faced exactly the same thing in his story, in his family. He bought a small whole life policy.
00:05:24.300 | And so ultimately, he became one of the biggest crusaders and his company made a huge impact on the life insurance industry and a good one on the life insurance industry to change the approach and utilize more term life insurance.
00:05:41.300 | And it's done so many families a tremendous amount of good. But you have to start with the proper amount of insurance.
00:05:48.300 | So let's answer that question today. Last week in – there are two episodes that I would like you to have heard before listening to this show, although this one can stand on its own.
00:05:58.300 | But if you'd like more background, you might want to go back and listen to these other two shows.
00:06:02.300 | And the first one is episode 173 from last week called Economic Basis of Life Insurance and Individual and Family Uses of Life Insurance.
00:06:10.300 | In that show, I laid out the different aspects of insurance, what it can be useful for. I gave you a little sales pitch on why you should consider owning life insurance.
00:06:20.300 | And then finally, I talked about different methods, the three major methods of determining how much life insurance you need.
00:06:28.300 | And those three methods, again, are the human life value approach, a needs analysis approach, and then some variation of a rule of thumb, most popularly the multiple of income approach.
00:06:37.300 | You will want to have that background for today's show because today I'm going to just simply teach you how to do a needs analysis.
00:06:44.300 | You would also benefit from listening to episode 101 if you haven't heard that one.
00:06:51.300 | That one – that episode was entitled How to Calculate How Much You Need to Save for Your Kid's College.
00:06:55.300 | Specifically, I taught you how to do some financial calculations to do a present value analysis for a college need.
00:07:04.300 | And I walked through the details of the actual calculations.
00:07:07.300 | I don't want to repeat all of those details in today's show because it will take too much time with the calculator.
00:07:15.300 | I'm rather just going to sketch out for you the general outline and we're going to do some back of the napkin math instead of a very, very precise math.
00:07:23.300 | But any financial calculation that you try to do is run the same way.
00:07:30.300 | All we're trying to do is figure out a cash flow problem.
00:07:34.300 | That's ultimately all financial planning comes down to is cash flow, and that cash flow might be a lump sum.
00:07:39.300 | You'll hear that in today's discussion about lump sum versus income needs or the cash flow might be an income need.
00:07:45.300 | And if it's an income need, it might be an income need of 10 years or it might be an income need of 50 years.
00:07:50.300 | So all financial planning is basically cash flow planning.
00:07:53.300 | I'll leave that simple concept there for a moment and we'll come back and I'll do an entire show on that at some point.
00:07:59.300 | But once you get used to thinking about finance in terms of cash flows, it becomes very simple.
00:08:04.300 | So you might enjoy that as far as some background on how to actually do the calculations as background.
00:08:09.300 | We're going to keep calculations simple today.
00:08:11.300 | So when you're doing a life insurance needs analysis, I'm going to recommend that you do a needs analysis.
00:08:17.300 | The problems with the other two versions is, number one, the human life value approach where you just simply estimate how much money someone is going to earn over their lifetime.
00:08:27.300 | And then back it up to today and try to replace that with a life insurance amount.
00:08:32.300 | That's okay, but you can't really actually ever estimate it.
00:08:36.300 | And the other problem is it doesn't take into account what the resources and assets are that you have today.
00:08:42.300 | This is actually what insurance companies do.
00:08:45.300 | When you go to apply for life insurance, the insurance company will not permit you to have over a certain amount.
00:08:51.300 | And that amount is going to be based upon your income and your assets.
00:08:54.300 | There are different formulas at each company, different multiples, different ways of looking at it.
00:08:58.300 | But basically, the insurance company doesn't want you to be thinking, "Well, I'm worth more dead than alive."
00:09:03.300 | You might actually be worth more dead than alive, but they don't want that formula to be incredibly out of whack simply because it puts them on the hook for a possibility of what's known in the insurance industry as adverse selection.
00:09:15.300 | You might simply decide, "You know what?
00:09:17.300 | If I stick a gun in my mouth and pull the trigger, my family is going to be better off.
00:09:21.300 | I'm just going to go ahead and do that."
00:09:23.300 | So if you're making $15,000 a year, there's not a chance in the world that any insurance company or any group of insurance companies is going to give you $15 million of life insurance coverage.
00:09:33.300 | There needs to be an appropriate ratio there between your income and your – and the amount of life insurance that you can actually get.
00:09:41.300 | So that's a major problem with the human life value approach.
00:09:44.300 | The problem with the rule of thumb approach is also that it doesn't take into account what you actually have.
00:09:48.300 | So if you just say, "Well, I buy 10 times my income of life insurance," well, what if I already have 10 times my income of savings?
00:09:55.300 | So it might be useful as a starting point, but the needs analysis approach is really not that difficult.
00:10:00.300 | So that's why I'm teaching it to you in a very simple way.
00:10:03.300 | When you sit down to do a life insurance needs analysis, there are two components of it.
00:10:08.300 | There is the lump sum component and then there's the ongoing income component.
00:10:12.300 | Both of these things are simple cash flow calculations.
00:10:16.300 | One, it's a cash flow of a lump sum one time, zero – the number is zero.
00:10:21.300 | It just comes in right at the beginning.
00:10:22.300 | It doesn't continue.
00:10:23.300 | The other, it's ongoing income.
00:10:25.300 | But we're going to use that mentally to divide the different needs that we have.
00:10:29.300 | So if you're buying insurance on your life, then you're going to sit down.
00:10:33.300 | You're going to say, "What does my family need if I'm dead and gone?" and split those needs out into two components, lump sum needs, cash that's needed right at death, and ongoing income needs, cash that needs to continue.
00:10:45.300 | Cash that needs to continue on an ongoing basis.
00:10:49.300 | Lump sum needs – some of those lump sum needs will be quickly self-evident.
00:10:54.300 | A simple example would be funeral costs or burial expenses or cremation expenses.
00:11:00.300 | If you – those amounts will vary from person to person, from state to state, from country to country.
00:11:06.300 | But there's going to be some amount of money involved for funeral, burial, and cremation expenses.
00:11:12.300 | If you keep things simple, there's still going to be some money involved.
00:11:15.300 | And so it's a good idea to provide for that and make sure that those – that money is set aside for that.
00:11:20.300 | There might be costs specifically associated with your estate.
00:11:25.300 | So you might have – at the higher end of wealth in the United States, you might have estate taxes that are due.
00:11:31.300 | There might be the costs of approving the will in probate court.
00:11:36.300 | There might be attorney's fees or executor fees, things like that.
00:11:39.300 | Most people don't think about that until they get into a certain amount of wealth, but it is a consideration.
00:11:44.300 | There might be some debt that is oweable.
00:11:50.300 | So for example, let's say that you've entered into a debt that's due at the date of death, maybe some sort of business agreement or something like that.
00:11:57.300 | You need to sit down and look at your debts.
00:11:59.300 | You might just simply have some debts that you want to pay off.
00:12:02.300 | So a simple example, my wife and I, we have a mortgage on our house.
00:12:05.300 | Is it important to me that when I die, we pay off the mortgage?
00:12:09.300 | If I leave my wife with a paid-off home with no mortgage, then in the state of Florida, there's no way that she can ever be kicked out of that house.
00:12:18.300 | No matter what, she cannot be kicked out and evicted from the house unless the house is in an HOA.
00:12:23.300 | The HOA can actually foreclose on her and force the sale.
00:12:26.300 | But if she gets behind on her taxes or she gets sued or whatever, in Florida, we have an unlimited protection from creditors.
00:12:33.300 | So even if I had a massive house, she can't be kicked out of it as long as it's paid off.
00:12:37.300 | That's a valuable part of security.
00:12:39.300 | That can be very, very useful.
00:12:42.300 | So that would be one thing to consider.
00:12:44.300 | You might also consider establishing some sort of emergency fund or readjustment fund, just basically a pile of money that is set aside to help your family transition.
00:12:55.300 | That would – all of these come in under a lump sum of money.
00:13:01.300 | Generally, most financial advisors will try to keep it simple because it's impossible to actually know what the actual numbers would be.
00:13:09.300 | Are you going to have a $3,000 funeral or a $13,000 funeral?
00:13:12.300 | Who knows?
00:13:13.300 | Nobody knows really in advance until you start to get a little bit closer and you're willing to do some focused planning for it.
00:13:19.300 | But most people don't actually know what they're actually going to need.
00:13:24.300 | So what we tend to do as financial planners is just simply throw some money at the problem and use big numbers or use round numbers.
00:13:30.300 | Not big numbers but round numbers.
00:13:32.300 | So I'll often say, "Well, let's put aside $30,000 for any kind of final expenses, emergency fund, burial expenses, funeral costs, that kind of thing.
00:13:42.300 | Let's just go ahead and pay off the debt and make it simple."
00:13:45.300 | Simplicity is OK in life insurance planning, even simplicity that errors on the high side because you always want to keep in the back of your mind relative to the benefit, the premium dollars for term life insurance are very inexpensive.
00:13:58.300 | So you can be incredibly precise or you can just kind of round number it and either is fine.
00:14:05.300 | As long as you are getting in the right ballpark, then you're in pretty good shape.
00:14:09.300 | So you want to make sure that you set aside and figure out how much is needed for lump sums.
00:14:13.300 | The other side is ongoing income.
00:14:16.300 | So how much income does your family need and what is it needed for?
00:14:20.300 | So there could be things like the normal expenses of life, just the normal bills, mortgage payments or rent payments, utility expenses, insurance costs, taxes, food, clothing, transportation, things like that.
00:14:32.300 | There might be expenses that would go up if you died.
00:14:36.300 | So if I died, for example, what if my wife needed help with childcare or if she died, would I need help with childcare?
00:14:43.300 | I can't very well record a show here while I'm taking care of a couple of little kids.
00:14:46.300 | That's really challenging. So I would need a certain amount of childcare.
00:14:51.300 | Or I would need money to fund my lifestyle so that I didn't need to do the show and I didn't need to work for money and I could just simply then take care of my kids.
00:15:00.300 | So we got to figure out some kind of ongoing income.
00:15:03.300 | And then there might be periods of time in which you need some cash flow that's ongoing but it's going to end.
00:15:10.300 | So, for example, education costs. Is it important for you to set aside a certain amount of money for your kids' private school, primary school education or for their college expenses, things like that?
00:15:21.300 | Is it important to you to set aside a sum of money that would be available for your daughter's wedding?
00:15:26.300 | Is it important for you to set aside a sum of money that will allow your child to start a business or to go and go on walkabout and travel around the world for a year when they graduate from high school?
00:15:38.300 | Those types of things you want to think through and consider and just simply make a list of everything that's needed.
00:15:44.300 | If you can make a simple list of everything that's needed and then take a look at everything that's available, you'll be able to figure out how much life insurance you need.
00:15:57.300 | That's really all we are trying to do.
00:16:00.300 | We're trying to figure out what you want, kind of try to figure out what you've got, and then calculate.
00:16:08.300 | If you subtract what you've got from what you want, then we know how much you need.
00:16:12.300 | And that's it.
00:16:14.300 | Now, a few things you want to think about is what is your actual budget for your family?
00:16:24.300 | These numbers will be different for every person.
00:16:26.300 | The reason I want you to have first listened to episode 173 was because in that show I gave my little sales pitch to think about – think generously when it comes to insurance benefits.
00:16:40.300 | If you want to be very miserly with your insurance benefits, then you can do that.
00:16:48.300 | But I encourage you to start with thinking generously.
00:16:52.300 | One of the biggest challenges that will impact the amount of life insurance that you need is not the lump sum but rather the ongoing income because there we've got to answer two questions, how much income and for how long.
00:17:06.300 | Let's start with how much.
00:17:09.300 | Obviously, if my wife and I are married, we have a two-person household, and that two-person household allows us to experience a certain cost savings.
00:17:23.300 | It's more efficient for two people to live together than it is for two people to live separately.
00:17:29.300 | But it also comes with a higher expense than one.
00:17:36.300 | What I'm trying to say is that it's not exactly half.
00:17:39.300 | I don't account for half of the expenses, but it's not as though if I died, she would need exactly the same amount of money that she needs now.
00:17:49.300 | So the first thing you got to figure out is how much would your spouse or your dependent if you're doing this simply planning for a dependence, how much would your spouse actually need to maintain their lifestyle?
00:18:01.300 | Oftentimes, you'll see a number such as 70% or 80% of the pre-death lifestyle needed.
00:18:11.300 | So the idea is, "Well, I probably account for 30% expenses. There would still be some expenses that she would have, but I would count for 30%."
00:18:18.300 | That might be a useful rule of thumb.
00:18:21.300 | It might also not be.
00:18:22.300 | So for example, if I have very expensive hobbies or habits and I'm the spender in our relationship, well, then maybe it could be much more or vice versa.
00:18:32.300 | So you want to sit down and actually figure out, "Well, what would actually change?
00:18:36.300 | Do we have two cars?
00:18:38.300 | Would one car go away?
00:18:39.300 | Well, how much would that actually affect the car insurance payment?
00:18:42.300 | Do we have two houses?
00:18:43.300 | What would actually change?"
00:18:45.300 | And you got to come up with an amount of money that you're going to calculate for.
00:18:50.300 | And once you have that number, then you plug that in.
00:18:54.300 | The second thing is you got to figure out, "How long do I want this money to come in?"
00:18:58.300 | Many people first start thinking about life insurance when they have young children.
00:19:04.300 | That is, in our culture, the most suggested time at which people suggest you should consider getting life insurance, and that's when most people start thinking about it.
00:19:12.300 | Well, the question is, "Do you want income coming in for your family for three or four years until they can adjust, they can move out of the big house, they can move into a little house?
00:19:22.300 | Do you want money coming in for 15 years until your three-year-old child graduates from high school or for 20 years until your child graduates from college?
00:19:33.300 | Or do you want income to come in for the rest of your life?
00:19:37.300 | What are you planning for?"
00:19:42.300 | Many people will often, if asked the question in that manner, they'll choose the shorter amount.
00:19:48.300 | I have always encouraged my clients to do lifetime planning.
00:19:52.300 | Now, it's a lot simpler to do lifetime planning if you have financial planning software.
00:19:56.300 | It's a little more challenging to do it on the back of a napkin.
00:19:59.300 | The reason is if you have financial planning software, you can easily model things like social security retirement payments, things like the growth of retirement accounts over time and their benefit there.
00:20:11.300 | But the reason that I do it is because practically speaking, and that's all I'm focused on in this short discussion here, although legally speaking this is also true.
00:20:22.300 | Practically speaking, when you come together to form a marriage, you are forming an integrated economic unit in which both parties' contributions are incredibly valuable.
00:20:35.300 | And there's an economic component associated with that.
00:20:39.300 | The example from my life will probably most simply illustrate this for you.
00:20:44.300 | But my wife does not earn wages.
00:20:47.300 | She doesn't work for an employer. She doesn't have an outside business in which she earns income.
00:20:52.300 | I'm the person who generates the income for our household, and she's involved in promoting our family goals as a mother.
00:21:01.300 | That's her role in our relationship.
00:21:04.300 | My role is to provide income.
00:21:06.300 | Her role is to make sure that it's well invested.
00:21:10.300 | Now, in the context of our marriage, we are inextricably linked economically for the rest of our lives.
00:21:18.300 | And she has walked away from her ability to earn outside income.
00:21:22.300 | Thus, she's walked away from her ability to fund things like retirement accounts.
00:21:27.300 | She's walked away from her ability to earn income to set aside in various investments to provide for her financial security.
00:21:33.300 | Well, if I die, yes, she has a responsibility to continue caring for our children for a period of time until they're out of the house.
00:21:46.300 | But ultimately, I'm also responsible to provide for her in her later years.
00:21:53.300 | And it would be grossly unfair for me to assume, "Well, all I'm going to do, honey, is take care of the fact that if I die, then I'll take care of you until the kids are out on their own.
00:22:04.300 | Then you can go ahead and you can go back and go into the workforce and go earn an income, and then you can save for yourself for retirement."
00:22:10.300 | That would be grossly unfair.
00:22:13.300 | In my opinion, that would be immoral.
00:22:16.300 | That would be the dereliction of duties of a husband to care and provide for his wife.
00:22:22.300 | The problem is many people don't consider that.
00:22:27.300 | Oftentimes, and I have verbally – not actually, but I have verbally slapped more people, more men across the face.
00:22:37.300 | Men are particularly bad about this, especially if they're just meeting with me and their wife's not there.
00:22:41.300 | Across the face, "Oh, provide for 15 years."
00:22:44.300 | And then you expect her to do what?
00:22:48.300 | Especially for men, primarily – I think women are much more sensible about these things than men.
00:22:54.300 | So my comments here are directed at primarily at the males who are in my listening audience.
00:22:59.300 | But when you take – and when your wife puts her confidence and her trust in you to provide for her and care for her, and especially when she makes the decision to exit the workforce and focus or to diminish her earning capacity because it's impossible for two spouses to both have – you can't take a high career job and care for a family.
00:23:26.300 | It doesn't work.
00:23:29.300 | Unless you have an integrated family unit where your spouse is caring for the family and that frees up your time, two people cannot do that equally.
00:23:34.300 | You cannot – there's always a cost with everything.
00:23:37.300 | So if there's a cost, if you're going to be number one in your field and number one in your career and the number one producer on the job, that's going to come with a cost in your family.
00:23:46.300 | Or if you're going to be the number one family person and the number one parent, that's going to come with a cost in your career.
00:23:52.300 | There's no way to escape that.
00:23:54.300 | You may be able to employ strategies to mitigate the cost, but you can't escape the fact that there is a cost.
00:24:00.300 | So my point is don't forget about the responsibility that you have to provide for your spouse and their old age.
00:24:07.300 | Calculate that.
00:24:09.300 | So when I do these calculations, I always assume lifetime – a lifetime of planning.
00:24:15.300 | If I'm working with a husband and wife and I'm saying, "OK, what happens over here?" I always take into account the entire lifetime of life expectancy.
00:24:25.300 | That will automatically make the numbers grow substantially because then all of a sudden, most people are woefully underfunded for retirement.
00:24:33.300 | Now when I immediately add on retirement funding into a life insurance analysis, that's going to tack on, what, half a million bucks, a million bucks of coverage?
00:24:42.300 | Most of the time – in fact, I can't remember ever though when actually explaining that, that I haven't had somebody say, "You know what? That makes sense."
00:24:49.300 | But you have to be careful because much of the advice that you read surrounding life insurance or the way that many people think about it, they think about it from a time period of only 10 or 15 or 20 years.
00:25:01.300 | So you've got to consider how long are you going to provide income for your family.
00:25:05.300 | One more thing that you need to consider and then we're going to do some example calculations here is when you are figuring out how much money you need to provide for the stream of income, are you going to use a liquidating approach or a non-liquidating approach?
00:25:23.300 | Here's what that means in non-financial planner lingo.
00:25:27.300 | Are you going to spend just the interest from an investment account or are you going to spend the interest in principle?
00:25:36.300 | You need to know which of those approaches you're going to use.
00:25:40.300 | Sometimes in the financial planner world, this is called the difference between a financial needs analysis and a capital needs analysis with the idea being that a capital needs analysis is not a liquidating fund.
00:25:52.300 | Rather, you just simply have a lump sum of capital and you're going to live off of the interest.
00:25:55.300 | There's not a right or wrong answer here.
00:25:57.300 | You can do either and I've done both.
00:26:01.300 | I prefer the simplicity of the non-liquidating approach, but you're obviously going to have a higher amount of money.
00:26:09.300 | If you're just going to live on the interest from your investments and you're not going to use the principle of your investments, then obviously you're going to need a higher amount of money.
00:26:19.300 | So why do it?
00:26:21.300 | Well, it's challenging to get all of your variables exactly right when you're calculating a liquidating approach, especially if you have a relatively short time period.
00:26:33.300 | So if I say I need to provide a lump sum of money for 20 years – excuse me, I need to provide a stream of payments for 20 years and I have a lump sum and I want that lump sum to be gone exactly in 20 years, how do I do that?
00:26:46.300 | It's very challenging to do that with an individual investment account.
00:26:50.300 | The easiest way to do that is with a simple annuity and you can just simply buy a 20-year payout annuity from an insurance company.
00:26:56.300 | But the reason the insurance company can offer such a product is because they have the benefit of large numbers of people over which they can make various contracts.
00:27:05.300 | But as an individual, if you die and your spouse is just simply trying to calculate their own investment approach, how do you figure out exactly what to invest in, when to invest it, etc.?
00:27:16.300 | So it's practically speaking, especially if you're dealing with a 20-year stream of payments, something like that, it's challenging to figure out the liquidating approach.
00:27:26.300 | Where I do often use liquidating approach is when I'm using financial planning software or over a large period of time.
00:27:33.300 | And the reason is when you take it out over a large period of time and you factor in all of the other things that are easy to calculate with financial planning software, things like social security payments, either widow and orphan payments or retirement payments, it's much easier to look at the whole scenario and put in your assumptions.
00:27:54.300 | But if you're doing this back of the napkin, I would suggest to you that you just go with a simple interest-only approach and just assume that you're not going to spend – you're not going to spend the principal and your family is just going to live on the interest.
00:28:06.300 | So let me give you a simple example and with just some made-up numbers, but pretend that someone like me, I'm a 30-year – almost 30-year-old father of two and my wife is a stay-at-home mom.
00:28:21.300 | Then pretend I have these certain amounts in my financial life.
00:28:24.300 | Pretend that the only debt that I have is a mortgage and I owe $150,000 on a home mortgage.
00:28:30.300 | And I sit down and I say, "Well, I need certain lump sums. I want to make sure that if I die that I have a paid-off home mortgage."
00:28:36.300 | That's a whole question in and of itself of whether that would be a wise thing to do or not.
00:28:40.300 | We could argue that another day. There are factors on both sides.
00:28:43.300 | But pretend that I simply say, "That's what I want. I want my house paid off. I want my spouse to make sure that she is able to not even worry about – not have to worry about that."
00:28:55.300 | Then I sit down and say, "She's just going to need some money to pay for any kind of final expenses. So let's just pretend I want $50,000."
00:29:01.300 | That gives her, let's say, $10,000 to pay for a funeral. That gives her $40,000 of extra cash, emergency fund, unexpected expenses. I feel good about that.
00:29:11.300 | So I want to pay off $150,000 of debt and I want to pay off $50,000 of final expenses.
00:29:17.300 | So then assume that I say, "Well, I want to make sure that my kids have a good start in life and I want to take care of their education expenses."
00:29:25.300 | Now me personally, as many listeners will know, I'm not necessarily so worried about their college expenses, but I am very worried about their education.
00:29:34.300 | And I need them to have some starter funds. I want them to be able to have some money to go out and start a business.
00:29:41.300 | I want them to have some money to go on walkabout. I want them to have some money to be able to have some world-class experiences through their teen years, things like that.
00:29:52.300 | So let's say I want to set aside $50,000 for each of them. If you want to do this very precisely, you can do all of the discounted calculations for college expenses that I outlined in episode 101.
00:30:05.300 | That's where you can find out how to do that. You can do exactly that and figure out the lump sum today.
00:30:09.300 | Let's just say, though, round numbers. I need $50,000 and I have two kids, so I need to make sure there's $100,000 set aside.
00:30:16.300 | So now if I add those numbers up, $150,000 for the debt, $50,000 for the final expenses and emergency fund, and $100,000 for my kids' college or otherwise education expenses, I need a lump sum of $300,000.
00:30:29.300 | But then I look at my balance sheet and I look at that and I say, "Well, what assets do I have that are immediately available if I die?"
00:30:38.300 | And pretend that I have $50,000 available in liquid assets. So liquid assets, things like savings accounts, cash or cash or cash equivalents, things that are not buried in retirement accounts, things that are not taking time to be sold.
00:30:53.300 | I'm not talking about a rental property that has to be liquidated at a fire sale, just liquid assets.
00:30:57.300 | And pretend I have $50,000 just in savings and emergency funds.
00:31:01.300 | Well, then what I do is I can subtract that from my need. So I figured out that I need a lump sum of $300,000, but I subtract $50,000 of liquid savings, liquid assets, and now I actually need $250,000 of insurance to cover those lump sum needs.
00:31:21.300 | So now I figured out I need $250,000 at least of insurance, but that doesn't provide income for my family.
00:31:29.300 | So I then sit down and I say, "Well, if I had a paid-off home mortgage – so I had a paid-off house. So I can take that out of my current budget, whatever that mortgage payment is.
00:31:41.300 | But I need to make sure to only pull out the principal and interest payment because there's still going to be taxes and insurance.
00:31:47.300 | But if I had a paid-off house and I want – then how much money do I want to make sure my family needs on an ongoing basis?"
00:31:55.300 | So I'll start with a simple way. I actually say, "Well, I want to have $4,000 a month of ongoing income for my family."
00:32:03.300 | And for me, it would be important – I would prefer to use the capital approach to be able – for them to basically be able to live off of the interest.
00:32:11.300 | Now, their ability to live off the interest will obviously be due to what is it actually invested in.
00:32:17.300 | And I don't want to get into the weeds of that conversation today. So just stick with the simplicity.
00:32:21.300 | Don't worry too much about the investing. Don't worry too much about the inflation. Just stay simple for right now.
00:32:27.300 | I would be comfortable in a scenario like this with the calculation of a 4% withdrawal rate on this type of portfolio.
00:32:35.300 | The reason that I would be comfortable is because I have – my family has backups.
00:32:41.300 | So I have backups of knowing that, A, they could adjust their income because I've got a paid-off house and no other debt.
00:32:47.300 | B, that I'm going to provide the same amount of money ongoing. I'm not going to be doing this very tight.
00:32:53.300 | I'm going to be providing the same – in the sense that I'm going to be providing the same amount of money when my kids are young.
00:32:58.300 | And it's likely that my family is going to need more money than when they're older and on their own and independent.
00:33:03.300 | And it's likely they're going to need less money. So I've got a margin of safety there.
00:33:06.300 | And then I've got margins of safety with knowing that my family would be entitled to Social Security, widows, and orphan benefits for my kids until they were 18 and for my wife until my kids were 16.
00:33:16.300 | And then also there would be retirement benefits for my family, for my wife based upon my earnings record if it were the higher.
00:33:24.300 | It's the higher in my family. So it would be based upon my earnings record.
00:33:27.300 | So now I sit down and I say I want an ongoing income of $4,000 a month and I'll use the 4% rule as a way to calculate that.
00:33:36.300 | And I'll be comfortable with withdrawing 4% from an investment account on an ongoing basis.
00:33:42.300 | And I think that would pretty much last with those margins of safety. That would be a good enough guess.
00:33:47.300 | So I multiply 4,000 times 300, which is the reciprocal of 4%.
00:33:51.300 | And that means that I need a capital sum of $1,200,000 to provide that income.
00:33:58.300 | Now, if I didn't have those savings rates, then I would need to reconsider my number.
00:34:03.300 | I might go with something a little bit less if I didn't have the backups of Social Security, other things.
00:34:09.300 | But for simplicity, let's just go with that.
00:34:11.300 | So I need $1.2 million. But I sit down and I look at my balance sheet and I recognize that I already have money saved.
00:34:18.300 | And pretend that I have $50,000 set aside in retirement accounts.
00:34:22.300 | So what I can do is because that money is there and that would be available for retirement, I could factor that in to my capital amount.
00:34:31.300 | So I take $1,200,000. I subtract the $50,000 that I already have saved.
00:34:37.300 | And so I actually need $1,150,000 of insurance to cover my income needs.
00:34:45.300 | And so I add that $1,150,000 to the $250,000 that I calculated in the previous step, the lump sum.
00:34:52.300 | $250,000 for lump sums and $1.15 million for ongoing income.
00:34:58.300 | And together that comes out to a total of $1,400,000 of total life insurance needed.
00:35:04.300 | Now I know what the total amount of life insurance needed is.
00:35:08.300 | And that's useful. It's a good number.
00:35:10.300 | What if I already have some insurance?
00:35:12.300 | Well, then I just simply subtract the amount of insurance that I already have from the amount of insurance that I need.
00:35:18.300 | Pretend that I earn $100,000 a year and let's say that my job gives me a benefit of three times my annual salary of free life insurance.
00:35:26.300 | So that means I have $300,000 of life insurance at my job.
00:35:29.300 | Well, I just take $1.4 million, subtract the $3 million that I get at my job automatically, and I know that I need to buy a $1.1 million life insurance policy or multiple policies or however we decide to structure it.
00:35:43.300 | And what I've just done is figured out how much life insurance I need to have.
00:35:48.300 | As my circumstances change, then I can adjust accordingly.
00:35:52.300 | As your circumstances change, you can adjust accordingly.
00:35:55.300 | Let me just give a couple of simple examples to illustrate what I mean.
00:36:00.300 | Let's say that I go – five years passes by and I've paid off the – I've paid off $50,000 of my mortgage debt.
00:36:09.300 | Well, because I don't have to cover that $50,000 of my mortgage debt, then I can go ahead and drop my insurance by $50,000.
00:36:16.300 | Or if I've saved other money from my kids' education expenses, then I can go ahead and lower that amount.
00:36:23.300 | Let's assume that I've built other forms of income.
00:36:26.300 | Perhaps now in my example, we own a rental property and that rental property pays a net rental profit of $1,000 a month.
00:36:37.300 | Well, depending on whether I have a mortgage on the property or not, maybe I need to increase the mortgage amount slightly or I need to cover – I want to say I want to make sure that now I pay off the mortgage on the rental property as part of my calculation.
00:36:49.300 | But because I have $1,000 a month, I no longer need to cover the $4,000 a month from life insurance.
00:36:55.300 | I just need to cover $3,000 a month from life insurance, and so that will adjust the amount of insurance that I need.
00:37:02.300 | As my assets grow and as my investment streams and income streams grow and as my needs get smaller – again, children are growing.
00:37:14.300 | Let's say that my children are now supporting themselves. Now we're more sure of what things happen.
00:37:20.300 | I can reduce the amount of insurance that I need.
00:37:23.300 | Over time, it's possible that I could reach the point where I no longer need any life insurance.
00:37:28.300 | Once I reach the point of financial independence where I no longer need to work for money, by definition, I now have enough assets to support my family.
00:37:38.300 | And so if I died, then my duty to make sure that things are taken care of is already covered and I no longer need life insurance.
00:37:47.300 | Practically speaking, what many people who reach that situation find is that they still value having the life insurance, but it's not technically a need just to support my family.
00:37:57.300 | Now it might be a useful way to leave an inheritance for kids, or it might be a useful way to provide an extra measure of security, or it might be a useful way to provide cash.
00:38:09.300 | But technically, we go into a different type of planning process.
00:38:13.300 | It's still just simply a lump sum calculation or an income calculation, but it's just it has a different name on it.
00:38:23.300 | So a simple example, I've got two kids. One of my kids is going to inherit my business.
00:38:28.300 | How do I make sure that the business stays all put together for one child but without disinheriting the other?
00:38:35.300 | If the business is worth half a million dollars and I don't have another half a million dollars to give to the other child, how do I make sure I do it?
00:38:41.300 | Very simply, I might buy a life insurance policy.
00:38:44.300 | That way when I die, my half a million dollar business goes to one child and my half a million dollars of life insurance payout goes to the other child.
00:38:51.300 | It might be worth it to me to pay the premiums to fund that.
00:38:55.300 | It's called an equalization of the estate is what that essentially is doing, is saying how can I equally distribute my assets with assets that aren't easily divided.
00:39:06.300 | It's really no different, though.
00:39:08.300 | Today, the only thing we're doing is saying what do you want, what things are important to you, clarifying those things, assigning a price tag to your goals, and then figuring out what assets or what resources do we apply to those goals and how can we best pay for the price tag.
00:39:27.300 | It's simple. It's not that big a deal.
00:39:30.300 | This is really all you need to do and you can sit down on the back of a napkin and use this very simple approach to figure out how much life insurance would be a good ballpark for you.
00:39:40.300 | One final note and then I'm done.
00:39:43.300 | The amounts of life insurance can vary drastically depending on the assumptions involved.
00:39:50.300 | I've given a number of assumptions in this show.
00:39:56.300 | Depending on what numbers I use, so for example, I used a 4% withdrawal rate.
00:40:01.300 | What if I used a 3% withdrawal rate?
00:40:04.300 | What if I wasn't comfortable with the assumptions involved in a 4% number?
00:40:09.300 | What if I had factored in and said, "Well, I want to make sure there's $4,000 a month coming in for the next 15 years, but then after that, $3,000 a month for the next 30 years, and then after that, $2,000 a month for – I can calculate that stuff and it's going to dramatically affect the amount of insurance."
00:40:24.300 | So if you're sitting down and looking at an analysis or working with it, pay careful attention to the assumptions involved and make sure that the assumptions involved are assumptions that you are comfortable with.
00:40:35.300 | And if you're comfortable with them, then you'll be happy with the number.
00:40:39.300 | But I could in many ways, I could manipulate a needs analysis to demonstrate anywhere from – this one is at $1.4 million.
00:40:47.300 | In this same example, I could argue my way into justifying as low as what, half a million or $750,000 or as high as a couple million dollars.
00:40:57.300 | All I need to do is factor in different assumptions.
00:41:00.300 | All I need to do is say, "Well, my wife would go back to work and she would earn $4,000 a month for 20 years and this, this, this," and those are all valid planning assumptions.
00:41:10.300 | So although I can get this extremely precise as far as the math, recognize that what I can't get precise is knowing what would actually happen in the future.
00:41:21.300 | So just make sure you're comfortable with the assumptions involved in your planning scenario.
00:41:25.300 | But hopefully this gives you a useful approach that you can use to actually sit down and figure out how much life insurance you need.
00:41:31.300 | And you can do this whether you are 25 or whether you're 75.
00:41:35.300 | Sit down, "What do I want? What do I actually want to happen? What's the price tag of that? What do I have? What assets that would be available to fund this need?"
00:41:48.300 | And then calculate from that, "What do I need and where is that need going to come from?"
00:41:54.300 | Sometimes it'll come from life insurance.
00:41:56.300 | Hopefully this is useful to you. I enjoyed doing this. I'm trying to keep this episode as a very focused episode.
00:42:02.300 | Feel free to share it with somebody if you're ever just thinking to yourself, "Man," or you're having a question from somebody, or if you're sitting down with an insurance agent and you're trying to calculate that,
00:42:12.300 | this should be a good introduction to the subject so you can more easily follow the way that the insurance agent might calculate it for you to help you figure out what's appropriate for you.
00:42:21.300 | Love your feedback on it. Let me know if you can follow this.
00:42:24.300 | I tried not to get too deep in the weeds with the math, but hopefully this was a good approach.
00:42:29.300 | Lots more coming in the life insurance series. We're going to talk about who should own a policy, who should be the beneficiary of the policy, how should you structure the policy, what type of policy.
00:42:39.300 | We'll cover the lengths of various policies. We'll cover all kinds of stuff in depth, but I'm trying to do it in a systematic way that'll be useful to the vast majority of people in a building process.
00:42:52.300 | So I hope I'm achieving it. I promise at some point we'll get into whole life insurance.
00:42:57.300 | At some point pretty soon. I won't make you wait for months and months, but we do need a little bit of a foundation here.
00:43:03.300 | Because again, once you understand it, it's really not that big of a deal. It's really not that big of a debate, I guess in other words.
00:43:11.300 | Once you understand the needs, financial planning is very simple. What do you want? What's the best way to get to it?
00:43:18.300 | And again, think to Monday's show on asset allocation and asset location. Once you figure out what I'm trying to accomplish, then you can figure out what type of asset should I use to fund this with.
00:43:30.300 | And different assets just don't make any more sense. And it makes no more sense to... Once you are clear on what the goal is, it makes no more sense to buy a...
00:43:40.300 | My language isn't working, but the car example. If you say I need a big truck to haul a heavy trailer, you don't wind up with a Honda Civic.
00:43:49.300 | On the other hand, if you need a commuting car, you don't wind up with an F-350. Well, you do if you live where I live.
00:43:59.300 | Most rational people would recognize that a Civic might make a better car than the F-350 for commuting.
00:44:06.300 | Anyway, I'm out of here for today. Thank you so much. I'd be thrilled if you guys would support the show. Please go to RadicalPersonalFinance.com/patron.
00:44:12.300 | If you found value in today's show, RadicalPersonalFinance.com/patron has all the details. Cheers. See you all tomorrow.
00:44:18.300 | Thank you for listening to today's show. If you'd like to contact me personally, my email address is Joshua@RadicalPersonalFinance.com.
00:44:28.300 | You can also connect with the show on Twitter @RadicalPF and at Facebook.com/RadicalPersonalFinance.
00:44:35.300 | This show is intended to provide entertainment, education, and financial enlightenment.
00:44:42.300 | But your situation is unique, and I cannot deliver any actionable advice without knowing anything about you.
00:44:50.300 | Please, develop a team of professional advisors who you find to be caring, competent, and trustworthy, and consult them,
00:45:01.300 | because they are the ones who can understand your specific needs, your specific goals, and provide specific answers to your questions.
00:45:11.300 | I've done my absolute best to be clear and accurate in today's show, but I'm one person and I make mistakes.
00:45:18.300 | If you spot a mistake in something I've said, please help me by coming to the show page and commenting so we can all learn together.
00:45:26.300 | Until tomorrow, thanks for being here.
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