How Much Life Insurance Do You Need?

My wife and I each have $2M of term life insurance.

Why $2M?

Because that's how much it would take for us to ensure the survivor is financially independent for life.

Want to know how much life insurance you need?

Well, let me tell you.

For this calculation, you need to assume you die tomorrow.

While that's not likely, you're trying to figure out the financial risk that exists today.

And then you're going to pay an insurance company to take that risk for you.

The amount you need depends on how much risk you want to transfer to the insurance company, and how much you want to retain.

Some people are comfortable just covering their debts.

In those scenarios, the survivor is expected to continue working and fund their own needs.

In other cases, like mine, you might want to ensure that the following expenses are fully covered:

- debts

- lifestyle expenses

- funding for kids' education

- retirement funding

- final expenses

It's a spectrum, and you'll need to discuss this with your partner first.

1. Debts:

This is fairly simple.

Total up the amount of all outstanding debts, including:

- mortgages

- lines of credit

- loans

- credit card debt

For most people, this is the absolute minimum coverage they should consider.

2. Immediate cash needs

Consider an additional amount to cover any immediate cash needs:

- emergency fund

- final expenses

- short-term expenses that were planned for but not funded, like a new car or home maintenance.

Things get a bit trickier from here on out.

3. Income replacement

None of us know exactly how much income we'll make over our lifetimes, but a reasonable way to calculate this is using your current income.

But two factors affect this number:

1. Inflation

2. The expected return on the survivor's portfolio

Assume you're 30 years old and making $100k per year after tax.

And say you expect a 6% annual return and 2.50% inflation.

That's a 3.50% real return.

Now you can use a 'present value of an annuity' calculation to determine how much capital you would need to replace your income for a fixed number of years.

That's about $2M to replace $100k for 35 years, adjusted for inflation.

https://www.financialmentor.com/calculator/present-value-of-annuity-calculator

4. Retirement costs

If the survivor needs $100k in retirement income and assumes a 3.5% safe withdrawal rate, you need close to $3M in retirement assets in today's value.

First, figure out the future value of $3M using 2.50% inflation:

https://www.calculator.net/future-value-calculator.html

That's over $7M in future value 35 years from now!

Assuming a 6% return, you would need about $1M today to cover that:

https://www.calculator.net/present-value-calculator.html

Of course, you could consolidate steps 2 and 3 to make this easier.

If you assume the survivor needs $100k into perpetuity, at a 3.50% safe withdrawal rate and adjusted for inflation:

$100,000/3.50% = $2.85M.

Close to adding the amounts from steps 2 and 3 together.

So in this scenario, we need debt coverage, plus about $3M to cover income replacement and retirement expenses.

Add in education costs, short-term needs, and final expenses if those are relevant.

From this, subtract any assets the survivor could access to to meet their needs.

For example, if you have a $1M investment portfolio that will pass to your spouse, you can subtract $1M from your life insurance needs.

That works out to about $2M in total insurance coverage needed for the individual in our scenario.

You might also consider whether the survivor would downsize the home and access some of the capital.

If so, you can deduct that difference from the need as well.

There are a ton of tools online to simplify all this for you.

The one I like the most comes from Manulife, and is free to use:

https://www.insureright.ca/about

A good insurance agent can run an "insurance needs analysis" for you as well to help you figure out your number.

Your life insurance needs are ever-changing, and your situation is unique.

Ideally, over time, your needs will decrease as your time horizon shortens and your net worth grows.

But remember, you're calculating your risk today.

Review it when there's a major life change.

Term insurance is extremely effective.

It has an expiry date, which makes it cheap.

In the future, my insurance needs will eventually be zero.

At that point, I'll cancel my insurance.

Almost everyone requires life insurance at some point.

So use the guide above instead to determine exactly how much insurance you need.

But remember, life insurance is only one component of a comprehensive financial plan.