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Do yourself a favor and re-evaluate your life insurance needs every few years, or whenever there have been significant changes in your personal situation. You’ll sleep better at night, and so will your family.
I just updated my financial plan and realized that I need more life insurance. Even though I’m a financial planner, I was surprised because I went through a thorough evaluation of insurance needs just five years ago.
But when I reviewed my current situation, I realized that the “facts on the ground” have changed. Like everyone else, my portfolio didn’t do as well over the last 5 years as I had hoped. As a result, my net worth isn’t where I thought it would be by now. When I started being self-employed, I had to get my own coverage. I bought my first policies based on:
a. How much it costs to support my family.
b. How much my family would have to invest in order to replace that support if I get hit by a bus.
c. How much we have saved so far.
I determined how much life insurance I needed by subtracting “c” from “b”. (Had the cost of supporting my family gone up, I would have factored that into the calculation as well.)
There’s another issue that came into play as well. When I first bought life insurance, I bought cheap term insurance that would expire in 2017. I figured that my net worth would be large enough to “self-insure” by that time.
I may still reach that goal but, the way things look now, it will be much more difficult. And what happens to my family if I don’t reach that goal before my insurance expires? I still have the responsibility to take care of my family in case a piano falls on my head.
In other words, not only did I need more life insurance, but I needed it for a longer period of time. That’s why I bought a new policy.
How do you apply this to your situation?
I strongly encourage you to re-evaluate your life insurance portfolio as soon as you can – especially if you haven’t done so over the last few years, or if your situation has changed quite a bit. Here’s the process:
1. Do you need life insurance?
Life insurance is a tool – not an investment. That’s why I like term insurance. You only need life insurance if others depend on your income. If you are retired and your spouse’s income would not suffer in the unfortunate case of your untimely demise, you don’t need life insurance (unless you have an estate tax problem ).
2. How much life insurance do you need?
There are many fancy calculators on the web that will tell you this, but let’s figure it out for ourselves.
Say you have (evil laugh) $1,000,000 and you want to create income from that money. You figure that, over many years, you could invest that money and earn, on average, 5% on it — or $50,000 a year.
I realize that you can’t get that kind of interest from a savings account, but there plenty of ways to generate income from investments other than by sticking it in the bank. We’re also talking about investing that $1,000,000 over a very long period of time, so earning 5% per year (on average) over many years isn’t unreasonable.
As it happens, you need $50,000 to support your family, so you’re happy with your situation. If your family doesn’t have you to generate the $50,000 that they need, they could your $1M nest egg to generate the income.
See also: “How much life insurance do you need?”
You might be thinking about inflation, and that’s an important issue. To address inflation, you really need to break out a calculator, though you might be able to get away without one. Here’s why:
On the one hand, the cost of living is certainly going to continue to rise. That means you may only need $50,000 to support the family now but it will cost a great deal more down the road. That’s true…
But on the other hand, the as time goes on, your family should need less support. Your kids will be older (meaning your expenses should decline), and your savings will grow. So the reduced expenses coupled with increased savings may cancel out the inflation problem.
Also, depending on the details of your portfolio and the withdrawal rate that you choose, you might be able to build cost-of-living increases into the amount of investment income that you devote to living expenses.
Ultimately, it’s very difficult to know exactly how much insurance you’ll need because the variables that change all the time (inflation rate, investment results, spending levels, and so on). That’s just another reason why you’ll benefit from re-evaluating your life insurance needs every few years.
How long has it been since you re-evaluated your life insurance needs? If you’ve done so recently, what did you learn? Did you have the right amount of coverage? Too much? Too little? If you haven’t double-checked your coverage, what are you waiting for?
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