Episode Transcript
Brenton: As Life Insurance Awareness Month comes to a close, it would probably be helpful for you to have an idea of how much life insurance you need in the first place. In this episode, we'll give you some tools to do just that. Let's get started.
Brenton: Hello, my name is Brenton Harrison of New Money, New Problems and your host for the New Money, New Problems podcast. September is Life Insurance Awareness Month, as we covered earlier this month. And before it [00:01:00] comes to a close, we wanted to do an episode where we talk to you about how to calculate how much life insurance you actually need.
I have said many times that I think life insurance is a legacy creator. I think the lack of life insurance has plagued a great number of communities and it's a real missed opportunity because if you can understand life insurance, you will see that it's an opportunity to transfer the risk that you might die and be unable to meet the needs of your surviving loved ones or organizations for which you may care, and you can transfer that risk for pennies on the dollar to the backs of the insurance company.
So I wanted to make sure that we aid in giving you some more knowledge To further that objective, and part of that is just starting with how much should I purchase in the first place? So I want to walk you through some of the factors that go into picking the amount of life insurance coverage. And then after the break, we'll actually go through a life insurance calculator so you can see how it works for yourself.
So what are some of those factors and how do they use it to give you an idea of how much you need now to replace that amount of income over a set [00:02:00] period of years. Well, there are a number of terms that I'm going to introduce to you now that may be foreign to you, but if you bear with me, I'm going to break them down one by one and hopefully this will give you a good understanding of how these calculators work.
Those terms are present value, future value, discount rate, and human life value. So let's talk conceptually through what each of these terms mean.
A fuller explanation or a fuller title for present value would be the present value of a future sum. In terms of money, it's essentially saying here's how much money you need today to make sure that you have a larger amount of money at some point in the future.
An example would be if I need a million dollars 20 years from now, how much do I need to invest today so that 20 years from now I have my million dollars? Whatever that number is that you need today, that is the present value of your future sum.
Future value works the same way in reverse. A fuller title would be the future value of a [00:03:00] present sum.
If I told you that you have a hundred thousand dollars today and 20 years from now, you will have a million dollars. Then that million dollars is the future value of your present a hundred thousand dollar value. Now, the third part of this equation is the discount rate, and discount rate is essentially an interest rate, and it's what you use to take a future value and figure out its present value. As an example, if I have a million dollars in the future and I have a discount rate of 5 percent over the course of, say, 20 years, it is saying that there is some number in the present where if I invest that amount at 5 percent a year for 20 years, then at the end of that period, I will have my million dollars.
The discount rate is the interest rate that your present value has to earn every single year to equal your future value at the end of that designated period.
I know that's a lot. So let's look at an actual calculator. So you can see this [00:04:00] with your own eyes. If you're following along with us on screen, we have what's called a present value calculator on the screen, and we're going to take the future value of a million dollars.
And we're going to take this over 20 years. So that's the number of periods that you see on screen. And we're going to give it a 5 percent interest rate, or in this case, a 5 percent discount rate. So if you're following along, we know that at the end of 20 years, you're going to have a million dollars and in the preceding 20 years, whatever you put in the market was earning 5 percent per year.
We want to figure out what number did you start with and that's the present value. When we run this calculation, what you find is that the present value of this future sum is 376, 889. 48. That's the amount where if you put it in the market today and it earned 5 percent per year for 20 years, you would know that at the end of that period, you would have a million dollars.
It's the present value [00:05:00] of a future sum.
So what does this have to do with life insurance? Well, if you can understand present value, future value, discount rates, so on and so forth, then you can understand the concept called human life value.
And human life value is essentially a way of figuring out the present value of future income streams. Remember, we're trying to replace income here. So for example, let's say that you earn 100, 000 a year and you're trying to replace that income for the next 30 years.
Maybe you have 30 years until retirement. If something happened to you today, you'd want to make sure that your family had that income for the next 30 years.
So what we're trying to figure out is how much money do we need today to generate 30 years worth of the income that Brenton would have earned had he not met his untimely demise.
Brenton: In my example where I'm earning 100, 000 a year and I was going to earn it for another 30 years, well that's... 3 million worth of income that I would have lost out, but there's a number of things that impact that 100, 000 [00:06:00] today is not going to be 100, 000 30 years from now.
Inflation will make what feels like 100, 000 today, actually a much larger number 30 years in the future. There's also things like the fact that my family, as I said, is not going to take three million dollars today, stick it in a savings account, and just peel off a hundred thousand dollars a year.
They're going to take off a hundred thousand dollars, and they're going to invest the rest of that money, however conservatively, and that rate of return that they earn is making sure that that money earns more money and as a result, they may not need 3 million today.
They may need 1. 5 million today to generate 3 million over the course of 30 years. Now do you have to understand how to calculate human life value? Probably not. There are plenty of life insurance calculators out there that will do it for you. We're going to show you one after the break, but I want you to understand the concept of how these numbers work so that it's not foreign to you when you say, Hey, I'm trying to [00:07:00] replace a hundred thousand dollars for 20 years.
That's 2 million. And all of a sudden you find out that the number that you need for life insurance is a different number. It's because they're applying a number of factors to that calculation that you may not be doing when you just take a hundred thousand and multiply it by 20.
Now we're talking about all these concepts, and if you're like me, you're very visual, so that may not have been helpful at all.
So let's get to the break, and after the break, we'll walk you through a life insurance calculator so you can see this in play for yourself.
[00:08:00]
Brenton: Welcome, welcome back. If you are following along on screen, we have a life insurance calculator up from a nonprofit called lifehappens.
org. They do a lot of great advocacy about the power and the importance of life insurance and they have a good life insurance calculator. We'll put the, link to this in the show notes of the episode.
And the first question they ask is how much annual income would you like to provide if you were no longer [00:09:00] here? This is their first question in efforts of finding the present value of these future income streams. What's the value of those future income streams? It's 100, 000 in our example. That's how much annual income.
We are trying to replace. So we click next on this question. How many years should your income be provided after you're gone? This is, if you go back to that human life value calculator that we went through before the break, the number of periods they're trying to figure out now that we have the income for how long does it have to be replaced, we're going to assume that it needs to be replaced for, let's just say 20 years in this example.
How much debt would you like to pay off immediately? This is that consideration. How much debt do I want to pay off? In this example, do I want to pay off a mortgage? No, I'm replacing the income that would have already paid.
That mortgage on a month to month basis. Maybe I don't have student loans, but let's say that my wife has 50, 000 worth of student loans, and I want to make sure that she can pay that [00:10:00] upon her death. So let's put 50, 000 click next.
The next question says, how much would you like to provide for child care? And this is also one that's a little interesting. You know, typically, if you're just saying, hey, the income that I earn each year is used to pay for child care, it might fall into the same scenario like the mortgage, where I say, hey, this is already being used to pay for these child care costs. You don't need to set aside a lump sum to cover these needs on top of that. But there are some scenarios where you might just say, hey, I realize that there may be some special things that I want for my children.
I might have a child with special abilities and there may be some things that I want to provide in terms of services. I'm no longer here. Cause if you're a parent of a child with special abilities, you are aware that in no way is your child a burden, but it is definitely burdensome to come up with the resources, the time, in many cases, the money to make sure that they're cared for in the way that you desire.
So you may say, I want to leave a lump sum to my children or this child to make sure that they're able to buy some things [00:11:00] that I would like in the event of my death. So let's say that we're going to put another 50, 000 aside for childcare in this example. How Many Children Require College Funding? This is another example of a similar version of human life value.
They're trying to figure out the present value of the future income needs. In this case, the future tuition needs. So let's say they have a child that's my son's age.
He's five. Let's say he's going to a public college and I live in the state of Tennessee. Let's hit next. Now, how much would you like to set aside for an emergency fund? Um, this is personal preference.
But I do like to make sure that if someone passes and is leaving loved ones behind, that they leave a few months expenses so that that person or that surviving family member doesn't have to rush back into work. So let's assume that this person has 5, 000 of monthly expenses. We are going to give their surviving loved ones six months to just grieve them.
So we're going to set aside an additional 30, 000. And then lastly, how much personal life insurance do you have? [00:12:00] If you already have a policy that you don't plan to replace because you think it's solid, that's going to reduce the amount of life insurance that you need. So we're going to put in 250, 000 in our example, and the reason I like this life insurance calculator is it gives you the total need.
In this case, it's saying that this person needs an additional 1. 7 million, but it also breaks down how each of those categories impact that need. As an example, under income replacement, they're saying that to replace that 100, 000 of income for 20 years, we need 1. 67 million. And it even says, if you click.
The information tab, this is the present value of future income needs. The calculation assumes an interest rate of 4 percent and an inflation rate of 2%. They're saying 4 percent is the discount rate. It is the interest rate that those funds will receive if invested in the market over the course of those 20 years.
And that 2 percent inflation rate, it just represents the increased cost of living. So just to replace income, we need 1. [00:13:00] 67 million dollars. That's typically a lot more than people predict and project when they're doing their own calculations. Debt to pay off. We put some of these numbers in ourselves. 50, 000 for debt, 50, 000 for child care, and college funding is another example of discounting those future income streams. In the information section, it says projected college costs include tuition, fees, room and board. The amounts being used are for the average four year education provided by the college board. So they're saying that if you want to make sure that by the time my five year old son reaches college, that he has enough to pay for four years at the average public school in this country, we're going to need to set aside 164, 000 just to cover that need.
The next is the emergency fund and burial costs. We put in these ourselves, 30, 000 for the emergency fund, 20, 000 for burial costs, and then we subtracted the amount of current insurance, that 250, 000. So in reality, it's saying that my current need [00:14:00] is over 2 million, but when you take out what I currently have in insurance, it drops it down to just under 1.
75 million. These are some of the factors that go into picking insurance need. And now once you have that need, which we'll cover in future episodes, you can take this number and you can go to a life insurance company, a life insurance advisor, a financial advisor who offers life insurance.
You can ask them for quotes to cover this life insurance need. And you can even dictate which portion of these life insurance needs are temporary, which are things that can be covered by term insurance, as we talked about in a previous episode.
And which of these needs are permanent, and those are things that could be potentially, either now or in the future, covered by a permanent life insurance policy. hope this was illuminating. I hope it wasn't too sobering talking about your future demise,
but I wouldn't be hammering these points home if it weren't so important. And I encourage you, if you have not already secured life insurance, or if you think that you might be underinsured to take the life insurance needs [00:15:00] questionnaire that we'll link to in the show notes and make sure that you apply for that coverage sooner rather than later.
I'll see you next week.
