Fine Tuning Income Replacement

by Bob Barney, President of COMPULIFE^® Software, Inc.
September 2000

The following article was published in the November 2000 edition of Canadian MoneySaver. For other important financial advice articles like this, Compulife recommends that you subscribe to the Canadian MoneySaver on-line magazine. The annual on-line subscription fee is only $24.95 CAD per year (That's less than $20 USD per year). Visit the Canadian MoneySaver website to learn more.

My last two articles for Canadian Moneysaver dealt with the subject of how much life insurance you should buy. I recommended that you buy enough life insurance to replace the income that you provide to your dependents.

The first article asked and answered the question "You're Worth How Much?" I said that your financial value was linked to the income that you earn and how long you'll earn it. I explained how to calculate the lump sum of money your family would need in order to generate an alternate source of income. Please note: a new "income replacement calculator" can now be found at my public term comparison website www.term4sale.com.

In the second article I talked about the other items that life agents typically say that you need life insurance for. As I explained, such things are tangents to the fundamental need for insurance (income replacement) and "baffle insurance buyers with trivial information that confuses and confounds". If you own enough life insurance to replace your paycheque, things like mortgage insurance, life insurance for children's education and insurance for retirement funding are not needed.

In this third and final article we'll look at how to fine tune the income that you need to provide, and how to provide it.

First, you don't need to replace all of your income simply because your family won't have to feed and clothe you anymore. That second car you have may become redundant if you die. Your spouse may no longer need to continue your membership in the golf club. You can reduce the amount of income that you earn and provide to your family by the cost of those things that are attributable to your personal existence. As a rough rule of thumb I used to assume that principle breadwinners probably personally consumed about 20% of their income. If you are earning $30,000 per year, you could probably plan to provide $24,000 per year.

Government pension plans may provide spouse and child income benefits. Look into it and find out how much. Don't assume that you will get the maximum allowed. Once you know how much the benefit will be, factor that into the total income your family will get and reduce the amount of income needed from your life insurance.

I disagree with those who assume their family will have to make lifestyle changes after their death. A typical statement I used to hear as an agent was, "My wife will go out to work." Anytime I heard that I'd ask, "Is she looking for work now?" The answer was usually, "No." I'd ask, "Why not, couldn't you use the extra money?" At that point it was explained to me that mom was too busy looking after the kids, taking care of the house, etc. I'd then ask, "How is that going to change after you're dead?"

Another argument I used to hear was that the family would sell the house they have now and move to a smaller house. My response to that was, "So is your house up for sale now?" The answer was, "No." At that point I'd ask, "Why not, couldn't you use the extra money that living in a smaller house would give you?" The response was, "But I like living here". I'd ask, "So why wouldn't your family like living here after you're gone?"

The point is this: why should your family be expected to suffer and sacrifice because you're dead and gone? Aren't they going to have enough trouble adjusting to losing you without having to make drastic changes to the rest of their lives?

More important, how much would any of these strategies really save in insurance costs? As I noted in the first article, a 40 year old male non-smoker, in very good health, can buy a $600,000 10 year term policy for less than $600 per year. Cutting the insurance coverage from $600,000 to $500,000 would only save about $90 per year. Just how much sacrificing do you expect your family to make to save $90 per year?

The next consideration is other sources of lump sum money. Suppose you have made all the reasonable adjustments to the income that your family will need from a lump sum, and you do the calculation and determine you need a total amount of $450,000. Now suppose that you have $100,000 in a G.I.C. investment and the money is not currently slated for any specific purpose. At that point you can reduce the $450,000 to $350,000. You can correctly assume that you have self-insured yourself for $100,000.

The key to this is "what" that asset/investment is being used for. For example, if that $100,000 is in your retirement fund, remember that your spouse will also need to retire. If you argue there is $100,000 of equity in your home, the only way your family can get at that money is to sell the house or take out a mortgage. Selling the home alters the lifestyle (discussed earlier) and taking a mortgage adds strain to the monthly finances. Simply put, do not assume assets can be used for income replacement unless they are not already committed to a specific purpose. For example, if the cash was for a boat you were planning to buy, that's different.

During my early days as a life agent I remember one gentleman and his wife who were in their 50's. They asked me to review their life insurance; they had several policies. I took at quick look at their existing policies then discussed with them their overall finances and plans. I learned they had inherited a large sum of cash which was invested in various liquid investments. The entire amount exceeded their needs for retirement or replacement income. I told them I couldn't understand why they needed to have any life insurance and suggested they get rid of the life insurance they had. They were delighted at the advice; no life agent had ever told them they didn't need life insurance. They promptly got rid of their insurance and referred me to their children and friends who ended up buying quite a bit of insurance; insurance those folks did need. The point is this: if the money's in the bank, you don't need the insurance, you're self-insured.

In terms of the total lump sum needed for replacement income, don't forget your group insurance at work or the mortgage insurance you may have with the bank. Those insurance values should be considered part of the total you need to come up with lump sum for income replacement.

Regarding group insurance, only add it in if you have been steadily employed with the same employer and only if they have had a good group plan that you believe will continue. If your group insurance coverage is $100,000, then reduce your need for personal insurance by $100,000.

If you have a mortgage insurance policy for $80,000, then you can reduce the insurance for income purposes by $80,000. While the $80,000 should not factor into the total amount that you actually need, it becomes part of the total that you have to meet that need.

Note: Make very sure that you are not overpaying for group or mortgage insurance. A certain amount of group insurance may be provided to you free of charge and that's a price you can't beat.

Many purchase additional group coverage believing that it is cheap. Make sure that you carefully compare prices. For example, find out how much the extra $100,000 of group insurance is actually costing you. When doing a term comparison first run the comparison for $350,000, then run a comparison at $250,000 to see how much difference in price you will save on buying that same coverage through individual insurance. As I noted earlier, a difference of $100,000 of term insurance, on a 40 year old male, was only $90 per year. Most people are very surprised at how little that extra individual term insurance costs.

The point is this: if the individual insurance is as cheap as group or mortgage insurance (and often it's cheaper), DO NOT buy group or mortgage coverage. Typically you can lose group insurance if you change jobs. Costs for your group may not be guaranteed. Mortgage insurance is no different. Changing banks on your mortgage renewal may mean you have to re-qualify for the new mortgage insurance policy and if you health has changed, you may not get it. Your individual coverage would be unaffected. Compare costs and only buy group or mortgage insurance if it really saves you money.

And finally, there is no point having life insurance unless you have dependents. If you have no spouse, no children, the reason for having life insurance is...?