The Boring Newsletter, 9/29/2024

Hi Friendos,

Today we are talking life insurance. If you die, would the people who depend on your income/labor be financially ok? Here are some common scenarios people (should) worry about:

• A partner whose own income is not sufficient to support their current lifestyle,
• A partner whose unpaid household labor would need to be replaced by paid services if they died,
• Kids who will need money to provide for their care and perhaps also for college, and
• Parents, siblings, or other family members you provide with financial support.

If you need life insurance, you should consider: (1) the amount of coverage you need, (2) how long you need the coverage, and (3) the type of insurance to purchase (answer: term life).

Sometimes people toss around rules of thumb like “you need coverage of 10 times your annual income.” Meaning that if you make $100,000 a year, you should have $1 million of life insurance. How could a universal rule provide meaningful guidance when people have such massive differences in their lifestyles and financial dependents? You can do better than an overly simplistic rule if you think about the specific problem you want life insurance to solve.

Scenario #1: You have one financial dependent who is your 15-year-old child, their other parent is entirely out of the picture, and your (not wealthy) sibling will care for your child if you die.

• If you died, you would want to provide them with $50k/year from now through age 18 to cover their overall support, and then with $120k to pay for college/technical school tuition and living expenses.
• You’ve already set aside $80k in their school fund and are on track to add $40k more over the next 3 years.
• After your child finishes their schooling, you expect them to begin working and be financially self-sufficient.  
• You need $150k (3 years of support at $50k/year) + $40k = $190k of coverage. Round that to $200k and then comparison shop for a 3-year, $200k term-life policy. If you die at any point over the next 3 years, there will be a payout sufficient to provide for your child’s care and higher education.  

Scenario #2: Your spouse works but earns less than you.

• If you die, you’d like them to be able to enjoy the same lifestyle, which would require an additional $40k/year in current dollars.
• They are currently 45 years old and, to be conservative, you assume they could live an additional 55 years, to age 100.
• You’d like them to invest any life insurance proceeds and be able to draw a bit off that investment portfolio each year. You think a 4% withdrawal rate seems reasonable, so can aim for them to have a $1 million portfolio ($40k / 4% = $1 million).
• Currently, you have a $200k investment portfolio your spouse would inherit if you died. You add $50k to this every year.
• If you died now, they would inherit a $200k investment portfolio.
• If you died in 10 years, they would inherit a $700k investment portfolio, +/- investment returns.
• If you died in 15 years, they would inherit a $950k investment portfolio, +/- investment returns.
• If you died in 20 years, they would inherit a $1.2 million investment portfolio, +/- investment returns.
• You could buy a 10-year term-life policy for $300k plus a 15-year term policy for $100k (an example of “layering” policies). Your coverage would go down as your net worth went up.
• By the time you reach 20 years from now, you will no longer need life insurance as your investment portfolio can fully sustain your spouse’s needs.

Most other scenarios look like one of these, or a combination of the two, where you are looking to provide a set amount of income for a limited number of years, to cover the cost of a particular event, or to provide income for life.

You may have noted my reference above to “current dollars.” In scenario #1, this is not too big a deal, as we are only talking about the life insurance covering a cap of a few years. In scenario #2, inflation is more important as we are talking about a longer period when the insurance is needed. Each year, inflation will reduce the purchasing power of an insurance payout. This will be offset by (1) your investment portfolio being invested in a manner to more than keep up with inflation (i.e., at least partially invested in stocks) and (2) yearly additions to the investment portfolio reducing the importance of the insurance payout. These offsets do not match up perfectly, but I’d call it good enough and you are light years ahead of a simplistic rule like “10x your annual income.”

If you’d like to read more about insurance, NerdWallet has a nice overview article about term-life, and White Coat Investor gets into lots of details explaining why other types of life insurance (whole life, universal life) are overpriced and the wrong life insurance product for nearly everyone (you can evaluate and potentially cancel one of these policies if an insurance salesperson convinced you to buy one).

-Stephanie