Life insurance can seem like a simple proposition: the coverage is there to ensure that your family has what it needs to get through your death and the years beyond it comfortably. But calculating just how much coverage you actually need can be more complicated than you might imagine.
30% of Canadians don’t have any life insurance at all. 33% of Canadians who do carry life insurance indicate that they feel they don’t have enough coverage. In fact, up to 76% of Canadian parents surveyed in 2013 stated that they felt concerned that their life insurance was inadequate for the needs of their family. Consider this story of a family who made a rookie mistake in buying their life insurance — a mistake that is perhaps the most common, and which people continue to make with disturbing regularity.
There’s no question that money is a major problem for many people. Taking on any recurring payment gives most of us pause. This is one of the toughest parts of buying a life insurance policy. But if that is what’s holding you back, you need to think about Jim and his family — and what happened to them after his death.
Jim, a 41-year-old man, was the sole breadwinner in his family. His 39-year-old wife, Anne, stayed home with their three children, ages 6, 9, and 12. Jim earned about $100,000 annually at his job, and this kept the family comfortable. However, their $300,000 mortgage and its $1,500 monthly interest-only payments, two car payments, credit card payments, student loan payments, educational costs, and other recurring payments ensured that the money was gone almost as fast as it came in.
Jim’s priority when he was shopping for life insurance was solely the monthly premium. He glossed over the specifics of the policy. To him, the details of the coverage were almost irrelevant, because he simply had to focus on the price. As a result, he purchased a term life policy that paid out only $500,000. The cost was $360 per year for the 20-year policy — about $1 per day.
Jim had more life insurance than most Canadians.
Another part of Jim’s rookie mistake here was relying on the life insurance that came with his job. This is a mistake for several important reasons. First, typically, these policies are inadequate for a family’s needs. In Jim’s case, the policy provided through his workplace provided a benefit of only $100,000 — not an unusual amount. Second, employment status can change at any time. Because this is true, you never want your only coverage to depend on your employment. Although Jim died when he was in fact employed, the third issue could have come into play: should there be any problem with the claim on your workplace policy, your family will be entirely without benefits if your workplace policy is your only life insurance.
When they were shopping for the policy, Jim and Anne really didn’t take the process seriously. They just didn’t believe life insurance was ever anything they would need. Of course, none of us wants to think of the worst-case scenario.
However, the worst did come to pass when Jim passed away in a car accident. Anne and their children were in shock. It was the worst time in their lives, and it was made even more difficult by the terrible lessons they learned based on how inadequate this life insurance policy was.
Jim and Anne just didn’t understand what they needed from their life insurance policy when they bought it. If they had, they probably would have thought twice when they made their decisions. At a minimum, life insurance coverage should be carefully calculated to cover the following expenses.
Funeral and other death expenses: Typically these will cost between $5,000 and $15,000. (The simplest of cremations without even obituaries or services will still require about $1,000 to be safe.) Even if the deceased qualifies for the maximum Canadian Pension Plan benefit, that benefit will be no more than $2,500.
Mortgage cost and any other debt expenses: In Jim and Anne’s case, the mortgage on the house was $300,000. Their payments had gone towards nothing but interest, so they owed the full amount on the house. As an average Canadian family, they had more than $28,000 in consumer debt and $30,000 in student loan debt outstanding when Jim died.
Educational and other costs for children: Experts say you should calculate your life insurance coverage to include the higher education expenses of your children (and, of course, ongoing educational and other expenses that they incur before college). In Jim and Anne’s case, their children’s expenses at the time of Jim’s death amounted to at least $6,000 annually. Their children attended summer camps, participated in extracurricular activities, needed clothes and some orthodontia, and needed other supplies. The oldest child would graduate in six years, so there would be at least six years of this cost, for about $36,000 total.
As for the children’s higher education costs, the average Canadian now graduates with $37,000 of debt. Obviously, the actual costs can vary, and if you have a better idea of where your children will be studying or what their costs will be, make your estimate that way.
Income replacement: If you have properly calculated the other expenses discussed above, most experts agree that you do not need to target 100% replacement of your income after your death. Instead, aim for between 50% and 70% of your pretax earnings for the years until your retirement. You can either calculate this literally, or do what some experts recommend and divide that portion of your salary you choose by 0.05 to come up with a target lump sum. Why 0.05? Because this figure works on the premise that your insurance benefits will earn about 5% annually as time goes on — a reasonable, conservative estimate.
In Jim’s case, that would be at least 24 years at between $50,000 for $1.2 million and $70,000 for $1.68 million. The simpler, more conservative target: $50,000 to $70,000 divided by 0.05. The latter is the lower number, and it still amounts to between $1 million and $1.4 million.
In the final analysis, Jim and Anne should have calculated a need of at least $1 million — even without adding in any college expenses for their children. Many professionals would have calculated their needs at closer to $2 million. Instead, Jim’s work policy paid out $100,000, and their personal policy paid out $500,000. Again, this put them way ahead of the average Canadian family. No wonder they figured they would be fine.
Jim’s death expenses amounted to about $15,000. Anne was immediately faced with large monthly payments and she wasn’t sure how to handle them. She had never entered the job market and was very concerned about that particular issue. If she paid off the house at $300,000 and the debt at $58,000, she would be left with only about $127,000 — just over one year’s salary for Jim. She sold one car immediately (at a loss), but still had one car payment, school expenses, and other things to pay for.
In the end, Anne was too worried about the future to take the gamble of paying off the house. She put it up for sale. In the housing market as it was, she ended up selling the house at a loss as well, but at least it didn’t end up as a foreclosure. She did pay off the consumer debt and student loans, which eased the monthly burden she faced.
Next, she had to decide whether to attempt to buy a smaller house or to continue to rent the smaller home she had moved the children to once the family home sold. She eventually found that she was in no position to buy, especially as her employment dilemma continued.
Anne looked for work, but her expenses with childcare were formidable and her lack of experience was a serious hurdle. She was forced to take what was essentially an entry-level position with a marketing firm, as marketing was her original major in college. Her mother was able to help her with childcare at times, but her health prevented her from taking it over entirely. As a result, the children were not able to participate in activities to the extent that they had before Jim’s death. Anne’s salary was low, and she relied upon the benefits from Jim’s policy — benefits that would likely run out before her salary would increase enough to compensate for their absence.
This family made a very simple rookie mistake in judging how much coverage they needed. In fact, almost all Americans find themselves underinsured. The good news is that you can avoid this mistake.
With term insurance in particular, beefing up your benefit is affordable. Jim’s 20-year term policy cost him $360 per year for a $500,000 benefit. However, he could have doubled his benefit for about $640 or $650 annually. Or he could have upped his policy to $850,000, for example, for a $575 annual premium. Meanwhile, Anne could also purchase a policy, and her policy would cost less unless she had a health problem or some other issue to cause her premiums to be higher. In fact, Anne could probably get $500,000 of coverage for just over $300 annually or $1 million of coverage for around $550 a year.
If Jim had spent just under $300 more per year, his family would have been in a much better position. And had he shopped around for the best insurer for his specific needs and compared rates, he would likely have found that as he added coverage in $100,000 increments, the cost increased for him — but in manageable chunks with most companies.
Don’t make the same mistake. Make sure your life insurance can do what it is meant to do: calculate the coverage you need carefully before buying.
