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Determining our Life Insurance Needs II – Scenario


Yesterday, I wrote about the criteria that needs to be considered when calculating life insurance needs.  Today, I'm going to calculate our personal requirement for life insurance in case the worst happens. 

Note that the insurance requirements for each spouse would be different if one spouse made significantly more money than the other spouse.  However, in our household, we make approximately the same income.

So looking through those criteria, here is what our financial picture would look like if one spouse were to pass:

  • Existing Life Insurance Benefit: $100k
  • Household After Tax Income: $3,200/mo
  • Portfolio value: $100k
  • Debt load if one spouse were to pass: $210k (mortgage and heloc)
  • Household Expenses: $2,900/mo (no mortgage/rrsp contributions/1 car eliminated)
  • Ongoing Childcare Expenses (20 years): $1,000/mo
  • Education fund: $40k
  • Funeral Expenses: $10k (CPP pays $2,500 upon death)

Lump Sum Debt 

So first, we need to cover our big debts which include our future mortgage and HELOC of $210k an education fund of $40k and 10k funeral, making our lump sum debt of $260k.

Cash Flow Requirements 

The next coverage we need to look at is cash flow.  Will the surviving spouse make enough in regular and portfolio income to cover the monthly expenses? 

If not, the insurance benefit should make up the difference. For us, expenses would be around $3,900/month including child care expenses.  This leaves us with a cash flow deficit of around $700 / month. 

We'll assume that salary raises match inflation and the insurance proceeds are reinvested in a non-registered portfolio and/or savings account.

Total Life Insurance Required 

Right off the bat, we need a $160k lump sum pay out after the existing $100k life insurance is accounted for. 

The $700/month or $8,400/year shortfall must be covered though a combination of the existing portfolio/cash and additional insurance.  Also note that income provided from a portfolio is taxable, thus must be accounted for in the calculations.

Our $100k portfolio/cash would hopefully be invested in growing dividend paying stocks (growing at the rate of inflation) paying out an average of 2.8% (after tax) or 3.5% before tax (NL tax rates).  This would bring in an additional $2,800/year initially leaving a shortfall of around $5,600/yr.

The shortfall lump sum amount required can be calculated with a couple of methods.

  1. Use all of the lump sum payout over 20 years: $5,600 x number of years required (20 years for us) = $112,000 (invested in a high interest rate savings account to counter inflation).
  2. Keep the insurance proceeds for life: $5,600/0.028 which pays dividends based on the payout = $200,000

Adding everything up:

$160k lump sum + $112k for cash flow supplement = ~$272k (no insurance benefit left 20 years after payout)

or

$160k lump sum + $200k for cash flow supplement =  ~$360k (insurance benefit remains intact)

Note that the insurance requirements would be even less should we decide to deplete our $100k portfolio/cash to $0 after 20 years instead of trying to keep the capital in tact.  However, I would feel more secure knowing that my wife would have an additional growing income stream for life. 

Final Thoughts 

Of course, as our net worth and savings grow, we will be less and less dependent on life insurance to financially protect our family.  Our plan is that in 20 years when our term life expires, we'll hopefully be completely self insured.  As of right now,  we'll most likely be going with the lower amount of coverage.

If you are wondering how much life insurance you should have, go through the steps that I did, OR punch the numbers into a life insurance calculator (like the one on Kanetix) (not aff).

The key point is that life insurance is to protect dependents against financial hardship not to make anyone rich. 

Photo credit: twocents 

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 11 comments… add one }
  • George March 3, 2008, 9:54 am

    $1000/mo for childcare expenses for 20 years??? That seems unrealistic to me – child care expenses are highest with infants and toddlers, drop once they’re in elementary school, and are pretty much eliminated once they’re in junior high (say, when they hit age 13 or so).

    Even if your kids were just born, you should only have to worry about child care expenses for the next 13 years, tops.

    • FrugalTrader March 3, 2008, 10:11 am

      Hey George, that extra $1000/mo adds a cushion for a 2nd child should we have one. I also expect the piano/ballet/sports, child care help to cost a fair bit/ month. Maybe it’s a bit overkill, but I don’t expect by much.

  • nobleea March 3, 2008, 11:58 am

    Hey FT, I don’t know if this is standard (I think it is), but my employer includes Accidental Death and Dismemberment coverage, which is on top of the standard 3 times annual salary life insurance.

    The most likely way someone under 40 would die is through an accident (unless there is already underlying health issues). AD&D is another 2x annual salary in the case of accidental death, for a total of 5x annual salary in the case of accidental death.

  • Michelle Dawn March 3, 2008, 4:05 pm

    I received the RRSPs book from your giveaway post and just wanted to say THANKS! It’s a great book and much needed :)

  • Ed Rempel March 3, 2008, 10:27 pm

    Hi Noblea,

    We actually consider AD&D insurance to be mainly a fun gamble with little practical use in most situations. When your family hears you died, they can always hope it was an accident so they can get a nice windfall!

    Death by accident is actually quite rare – even for people under 40. Only about 2-3% of deaths are by accident, which is why accidental death insurance is usually very inexpensive. Getting 2 to 5x your insurance benefit with AD&D is oftena only $5-10/month.

    The main reason it is not very useful is that few people need more insurance if they die by accident than if they die by any other reason, such as sickness. If FT gets AD&D, that still leaves his family unprotected against all the more common causes of death.

    Ed

  • Ed Rempel March 3, 2008, 10:51 pm

    Hi FT,

    You may be exaggerating your need for insurance. I have 2 questions for you.

    1. Isn’t your main need for insurance a result of your preference for living entirely on low dividend rates? If your investments were equity investments that averaged 8%/year long term (say 6% after inflation), instead of only 2.8% dividends, does that not eliminate your insurance need?

    Your options only include dividends only (not using the principal) or a savings accounts with using the principal. Why not BOTH – invest effectively and assume the principal is used.

    2. Why would you end all leverage on death? The insurance proceeds would allow you to convert the rest of your mortgage to tax deductible. Then the investmnents and the interest tax deduction can be used to replace your income. Wouldn’t continuing the SM and leverage help your situation (again if making more than 2.8%)?

    My other question is it sounds like you are not providing for RRSP contributions – is that right? Would the survivor not want to still save for retirement?

    Ed

    • FrugalTrader March 4, 2008, 8:20 am

      Ed,

      1. Yes, we would prefer to play it safe and assume the low growth and dividend rates. Who knows what the markets are going to do during the time that the surviving spouse needs the cash the most. Also, I would prefer some capital preserved to act as an emergency fund if not anything else. I guess when it comes to financial safety, I’m very conservative.

      2. With regards to leverage, the plan was really with my wife in mind. She is not as “financially literate” as I am, and i’m pretty sure that she would feel more comfortable without leverage. I realize that the life insurance plan is very customized for our family.

      Great point about RRSP contributions. If I were to pass, my wife has a gold ticket pension plan, so no worries there. If my wife were to pass, I would find a way (probably through leverage) to make sure that my retirement is paid for.

  • oOKitijimaOo March 4, 2008, 5:31 pm

    Hi FT,

    You mentioned that you are very conservative when it comes to financial safety.

    Have you ever considered growing your money in a life insurance policy? I’m not talking about Universal Life policy but rather a participating whole life.

    Imagine having the growth in a tax free environment and being able to have an income tax free.

    Rob

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