Term is a versatile life-insurance product. One of its principal benefits is to be able to function in income-replacement scenarios.
Income Replacement in General
Here’s the way term functions.
Consider a household with one income earner. Call him John. Let’s say John makes a $100,000. And let’s suppose that John is 30 years old. He’s married to Jane and they have two kids. Jane is a stay-at-home mom.
If John were to die, what would Jane’s income replacement needs be?
Let’s do some easy math.
I’m going to use what’s called a human-life-value approach to answering this question.[1]
If John’s retirement age is 67, then he has 37 years to work. If he makes 100,000 a year, then over 37 years he will make $3.7 million. It’s a simple multiplication problem: $100,000 per year times 37 years.
Think for a moment about why this figure is so large. And it does strike many people as large.
$3.7 million is $100,000 this year, $100,000 next year, $100,000 the year after that, and so on for 37 years.
I am abstracting away from cost-of-living increases, raises, and other things of that kind.
I’m also going to make the assumption that the family requires the entire $100,000 for expenses of one sort or other.
Some of the money that John makes each year goes to fund his care, buy his clothes, buy his food, and so on. If John lives the 37 years, and his retirement plans go off as expected, then some of the $3.7 million would likewise have been spent on him.
But if we’re supposing that John is now dead, then the $3.7 million may be reduced a bit to account for the fact that John’s expenses have been eliminated.
One standard approach is to multiply the product – our $3.7 million – by 70%.
When we do this, $3.7 million is reduced to $2,590,000.
This new figure is John’s rough human life value.
Even this reduced figure is still considerable.
Let’s suppose that John had a life insurance policy that would pay Jane $2.6 million in the event of his death. This policy payout is not supposed to make her a millionaire, allow her to buy a mansion, or fund a fancy car. Rather, it is supposed to reproduce John’s missing income year after year for 37 years. This would enable her to maintain her current lifestyle and would bring her into retirement as if John were still earning income for her in the family.
Now this is all very rough and ready. Many factors can modify our values and many considerations might change the way we approach the situation.
We’re not factoring in that the kids will ultimately leave the house, that Jane might be able to get a job herself, and many other things.
This is simply supposed to illustrate what life insurance is capable of doing. Life insurance can reproduce the income of a breadwinner that died too early. And many times, this kind of coverage makes all the difference in the world for a family.
It can make the difference between a family that is able to stay in its house, go to the same school, and grieve without worrying about money and another family that has to pay for funeral expenses with a Go-Fund-Me page.
Income Replacement in St. Louis
That’s the general idea.
The local news outlet KSDK.com recently published figures about area incomes by age. Using these figures, we can arrive at a rough idea about what various income-replacement scenarios might look like for St. Louis families.
Disclaimer: Your actual figures may be completely different. In order to arrive at the correct amount of life insurance for your family you should consult with a licensed professional. This article is for general informational purposes or entertainment purposes only. It is not intended to give financial, insurance, investment, legal, retirement, tax or any other kind of advice.
Having said that, here’s the way the numbers break down.
I will use two different approaches. Firstly, I will use the human life value approach that I illustrated above. Secondly, I will use the sort of rough and ready approach that is championed by personalities such as Dave Ramsey. On this approach, we simply arrive at term insurance need by multiplying yearly income by 10.
There are six age brackets we will be concerned with.
1) 20 to 24-year-olds
2) 25 to 34-year-olds
3) 35 to 44-year-olds
4) 45 to 54-year-olds
5) 55 to 65-year-olds
6) retiree 65+
We will use rough figures from KSDK. And I will average the income figures they presented. I will also assume a retirement age of 67.
Average income for 20-year-old would be in the vicinity of $28,000 per year. 20-year-old has 47 years to work until retirement. And again, Dave Ramsey recommends at least 10 times your salary. This gives us to amounts. $28,000 times 47 years equals $1.316 million. Offsetting by 70% yields $921,200. 10 times $28,000 is $280,000. Therefore, a 20-year-olds term insurance amount will range from $280,000 to $920,000.
Observe that, even though the 20-year-old person has the longest time period to cover, he or she also probably has a comparatively low income. Additionally, this young person may not yet have married or started a family.
30-year-old will make around $39,500 year. So again $39,500 times 37 is our equation. With 37 years to work his or her human life value amount comes to $1.4615 million. Again, offsetting by 70% gives us $1,023,050. 10 times $39,500 is $395,000. This is our range for 30-year-old: $395,000 to $1M.
Note that, as income increases, term-insurance need increases as well. For many people, it makes sense to stagger policies or increase coverage to correspond with pay raises. Another option is to use increasing term. (I will discuss this option in greater detail elsewhere.)
At 40, average income is around $50,500 a year. With only 27 years left to work until retirement we multiply $50,500 times 27 giving us $1.3635 million. When offset we arrive at $954,450. Dave Ramsey’s number would be about $505,000. So, we range from half a million dollars to around a million dollars in coverage.
The 50-year-old only has 17 years to work. At $51,000 a year on average we arrive at $867,000 times 70% gives us $606,900 of coverage. Using 10 as our multiplier it would be $510,000.
The 60-year-old also averages around $51,000 a year but with only seven years left work until retirement the human life value multiplier would drop to seven. $51,000 times seven is $357,000 which, when offset, is $249,900. And again $51,000 times 10 is $510,000. So, we’re down to between a quarter million and a half a million.
The traditional conception of human life value terminates at retirement. The assumption is that the insured person has adequately saved for retirement or that the life insurance payout included retirement funding expenses.
Therefore, for those 65 or older their human life value term need will only be one or two times their income at most. For those already at retirement age — which, we are assuming 67 — there is no human life value term need remaining (at least, not for salary or income replacement purposes). However, the average income is supposed to be around $52,000 a year which when multiplied by 10 could yield $520,000.
Having said that, if retirement planning has not been completed – or begun – and it is necessary to work beyond the Social-Security Administration’s “Normal Retirement Age” specification, then a human-life-value term need may yet remain.
Moreover, there are income replacement applications in retirement. These would include covering pension and Social Security benefits that may be lost to surviving spouses or family members depending on the payout options selected. However, this will have to be the subject of a different post.
For present purposes, and using St. Louis specific figures we can see that, regardless of age, a family’s total term-insurance needs may range from around $280,000 to over $1 million. In this is only using rough average or median figures.
Once again, your personal term insurance needs may be quite different. But hopefully you have gotten some idea about the ways term insurance needs may be calculated. If you are in the St. Louis area and would like a consultation or review of your own situation feel free to give me a call at 321-948-0707.
Notes:
[1] There are other methods.