How much Life Insurance is enough? Article by Daniel Glynn AFA from our February 2017 Newsletter
One of the principles of insurance is that of ‘betterment.’ Essentially, it says that one should not be better off by having insurance than if you did not have it. If we were all better off by having insurance, so the argument goes, we would invent or create situations that rendered us incapacitated to benefit from our cover! Interestingly, the one insurance that is kind of exempt is life insurance. Maybe it is because the person insured cannot literally benefit from it! However, literally, with a stroke of a pen one can create a legacy to leave behind to make others’ lives much, much better than their current situation, or does it just seem that way?
Most life insurance is written to enable family members, especially those dependent on them, to financially survive after the death of a bread winner, or carer. Having recently experienced assisting some of our clients with unfortunate recent claims, I have reflected on the ‘right’ amount of life insurance one needs, and find that most people do not receive a sufficient enough pay-out to replace their spouses’ income. If one is say earning $100,000 to keep the family going, at current savings rates, one would need approximately $810,000 lump-sum to provide that level of income for 10 years. We have not even begun to think about getting rid of debt, paying for a funeral, children’s school fees etc. etc.
As one insurance colleague commented, “I have never met a widow/widower who said that their spouse was over insured!” So, how do we make sense of it all, and how much is enough? Most insurance advisers will use a planning tool to work through with clients to understand what is important, and to work out what a client’s financial position is, and what it will be when the unthinkable happens. The formula I typically use is the following:
· Funeral Payment – the reality is, we have to plan for a funeral and it costs money, which has to be readily available. The average cost of a funeral is around $15,000 and this can be paid immediately from the life insurance cover. Unless you have cash in joint names, often a spouse cannot get hold of other assets such as KiwiSaver or shares, as these are subject to estate rules. Under the Property Relationship Act, an estate can be tied up for six months, leaving a spouse without ready cash!
· Debt clearance – I believe that leaving loved ones with the burden of debt is selfish and improper. At the absolute minimum, I recommend that ALL debt is covered by adequate life insurance. I also believe that securing the roof over the head of a family is of fundamental importance.
· Income Replacement – if a bread-winner dies, this also means that a salary has just walked out of the door! Getting a good financial planner to work out replacement income over a designated period is the best investment of time that you will do. Questions like: how much income is required for the family, given that debt is repaid; over how long – until children are 18, 21 or longer? What are the prospects for the surviving spouse to continue work and what are they realistically likely to generate? One of the biggest issues is for women or men that have taken time out, whether to raise a family or to study, is to consider how far behind the eight ball are they in terms of career development? How quickly can they replace the spouse’s income?
· Grieving period – I have found that each of us respond differently to grief. Some people respond by throwing themselves into work and somehow come out the other end. However, that is in my experience, the minority. The reality is that you do not bury a loved spouse on the Thursday and then go back to work on Monday. Some people take months to cope and adjust to the new reality. Children in particular often need support from their remaining spouse and there are new routines to be learned. Taking time out, away from the busy-ness of work is often healing and necessary. Building in an amount of cash to enable a person/family to do that is often essential. If a long illness has been involved, people report that having the cash to take the family off on holiday to relieve and revitalise them was a blessing.
· Children’s education – if a family has plans for private or tertiary education, this can often go out of the window if there is no money. Planning now for children’s educational needs is essential and building in enough cash in the life insurance plan is critical to make it a reality. It is really sad to see a family have to cut back on all their hopes and plans for kids, simply because there was insufficient provision for education.
· Retirement fund for Spouse – a key component of financial planning is thinking about putting money away for retirement. Particularly when there is a spouse left with young children, it may be years before realistically they can engage in high paying work. My suggestion is to build in a lump sum which can then be invested to provide an income in retirement, as there may not be the years ahead to build up a suitable lump sum through KiwiSaver or other retirement plans.
· Special – as mentioned previously, life insurance allows one to build in cash which can help to change the world. Many people leave money to charities, or wish to create a charitable fund which can create an on-going legacy.
With careful planning and realistic conversations, you can provide much or all of the requirements that suit your family. At the end of the day, you can only do as much as your dollar budget will allow. The challenge is to make sure you budget a decent amount on insurance. I am always gob-smacked by people who tell me that they cannot afford any cover, and then tell me that they are going on an overseas holiday! Insurance is a valid expense, and a necessary one, especially if you have debt or dependents. I recommend engaging a professional financial planner to work out the level of cover and then work backwards on affordability. As an old boss used to say, “Something is always better than nothing.”