Life insurance seems like a complex topic. It’s also morbid, so many people choose not to think about (or worse, they let it sit in the back of their mind continually nagging and sapping energy).
The good news is that like many financial products, life insurance only has to be as difficult as you want it to be. I divide the life insurance world into two parts: (1) insurance products and (2) hybrid insurance/investment products.
Life insurance products (also known as term life) work like you think insurance works. You buy a policy, pay a premium, and if the event happens, the policy pays out.
Hybrid life insurance/investment products can be found under names like whole life, universal life, variable life and variable universal life. If the names sound confusing, that seems to be the point. The less you understand, the easier it is for someone to tell you something that you don’t need. The bottom line is that hybrid life insurance/investment products combine both an insurance policy and an investment vehicle.
There’s no requirement to mix insurance and investment products. Want to keep things simple? Stick with term life for insurance and use your investment accounts for investing.
How much life insurance to buy?
Many people think you need life insurance without understanding why. There are various reasons for this, but the greatest might be in its name. Who doesn’t value their life? I must insure it! Unfortunately, life insurance has nothing to do with keeping you alive. It only pays out if you die, but the marketing folks thought that naming it “death insurance” wouldn’t sell as well.
The good news about life insurance is that it’s a straightforward product. You’re either dead or alive. There are no shades of gray. Being mostly dead isn’t a condition that you need to worry about.
But you might be asking, “Why do I need money if I’m dead?” And that’s a great question because you won’t need any money if you’re dead. The only people that might need money are people who depend on your income right now. If nobody depends on your income, you don’t need life insurance.
A lot of people trying to sell you life insurance might tell you that locking in a low premium at an earlier age could save you money over the long run. That may be true but depends on a lot of factors, including how long you plan on carrying life insurance (which may not be as long as you think if you’re reading this site). As always, run the numbers. There are not a lot of situations in life where it makes sense to pay for something that you don’t need today.
The second most common reason to sell you life insurance is by pointing out that you might not be insurable in the future. This is something to consider. If you develop a health condition, there’s no going back and getting life insurance. While I don’t think this means that every 18-year-old should run out and buy life insurance, it does mean that if you’re in your mid-thirties you may want to consider purchasing a minimum amount of life insurance today, assuming (1) someone will eventually count on your income and (2) that you want to take the risk that you’re uninsurable in the future off the table.
But let’s say that you’ve determined that someone does rely on your income and you want to buy an insurance product to cover the unfortunate possibility that you’re not around to provide that income.
How much life insurance should you buy?
Non-dischargeable debt. If you have any debt that doesn’t discharge upon your death, you’ll want life insurance money to discharge the debt. Student loans are typically dischargeable upon death (i.e., they are canceled). Personal loans, mortgages and that loan you took out to buy a boat are not. That means that if you die, your estate still needs to pay for those loans. If you have a $500,000 mortgage in your name and a $1,000,000 life insurance policy, the mortgage isn’t canceled because you die. After paying off the mortgage, there will only be $500,000 left on the policy.
Income replacement. Is your goal to replace your current income so that your family will continue receiving money as if you were still working? If you’re making $200,000 and you apply the 4% rule, that means you’ll need $5,000,000 of life insurance to replace 100% of your income. Many people find this number excessive for good reasons. One is that you may be at your peak earning potential right now but that you don’t expect to make your current salary forever. Another is that you may be close to your peak spending. If you’re paying off a mortgage, saving for retirement and raising kids, those things only last so long. Will you still need your current salary once you’ve achieved all of those financial goals? If you think your family would be okay with $100,000 of income, you could ratchet down that policy to $2,500,000.
Education. If you have children, many people think about getting a life insurance policy with enough money to cover future educational expenses. While it’s hard to predict how much education will cost in the future, I think it’s reasonable to set aside six-figures for each child’s education if this is a priority for you. The loss of a parent will be tough on your child, so paying for their education also seems like an obvious way to make their life a little easier.
Therapy. Similar to education, if you’d like to leave some money to help a child or spouse with therapy as they cope with the loss, this seems like a reasonable expense as well.
Life insurance is cheap. The great thing about term life insurance is that it’s incredibly affordable. This isn’t a product where you need to spend a lot of time dialing in exactly how much you’ll need to make sure your family is OK. You can pick a reasonable number and then round up by $500,000 without worrying that you’re making a financial mistake by purchasing too much insurance. I’d encourage you to do exactly that. Buy more coverage than you think you need.
How to ladder life insurance policies
Now that you have a rough idea of how much insurance to buy, the next obvious problem is that your life insurance needs change over time. A 30-year-old with a spouse and two kids needs more insurance coverage than a 60-year-old Biglaw Investor reader with a $5,000,000 net worth.
The more assets you have, the less life insurance you need.
Unfortunately, the 30-year term policies that a 30-year-old wants to buy are also the most expensive. A healthy 30-year-old male can buy a term life insurance policy for $1,500,000 that lasts for 30 years for about $81.91 a month. Meanwhile, that same policy for 10 years only costs $30.05 a month. While it makes sense for the 30-year-old to have the $1,500,000 of coverage today, he’s not so sure that he’ll need the same amount of coverage in his 50s when he plans on having more than $1,000,000 in assets.
If you’re planning on building your assets, you might want to explore buying multiple policies and laddering them to save on premiums.
Laddering policies work like this.
You decide how much coverage you want at the various stages of your life. Let’s say the same 30-year-old wants $1,500,000 today but thinks he’ll only need $1,000,000 of coverage at 40-years-old and $500,000 of coverage at 50-years-old.
He can buy the following policies to achieve the same effect:
- 30-year policy for $500,000
- 20-year policy for $500,000
- 10-year policy for $500,000
Laddering the policies allow him to control the amount of coverage as he’s building assets.
As you might expect, this approach will save you money. Let’s look at the same policies with the monthly premiums. Using PKA Insurance’s instant quote generator, I get:
- 30-year policy for $500,000 ($32.01/month)
- 20-year policy for $500,000 ($19.91/month)
- 10-year policy for $500,000 ($13.64/month)
This results in $1,500,000 of coverage for a total of $65.56/month. That’s already $16.35 less per month than the 30-year policy but don’t forget that those premiums will decrease over time as the policies expire.
There are a few common concerns when it comes to laddering policies:
Q) What do you do if you need more life insurance in 10 years when the first policy expires?
A) You buy more life insurance!
Q) What if I’m uninsurable in the future?
A) Did you buy enough life insurance when you were laddering the policies? Remember how I mentioned that life insurance is cheap and that you should buy more than you think you need?
Q) What if I bought enough life insurance, but I’m unable to save money over the next 10 years because I’m sick and can’t work?
A) Then you should be relying on your disability insurance to replace your income when you are unable to work. Disability insurance covers your income while you’re sick and unable to work, including the amount of money you need to be saving for retirement. Life insurance is for when you’re dead (and therefore definitely unable to work).
Let’s talk about it. Any other concerns not covered in the above? Let me know in the comments.
Joshua Holt is a practicing private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He spends 10 minutes a month on Personal Capital keeping track of his money and is always looking for honest companies that provide insurance for a fair price without selling you products you don't need.