Your ‘human life value’ may be more than you think

 

One of the most difficult financial issues to grasp is: How much life insurance is the right amount? Obviously, it”™s a difficult topic because of the human loss involved but also because people may try to determine it based on guesswork, “soundbites” from financial “entertainers” in the media, or what the next-door neighbor says ”“ and none of these is a reliable method for assessing such an important issue.

 

Calculating your value

Consider this example: A client of a colleague of mine felt his wife and two children would be fine with $1 million upon his death ”“ which sounded to him like a lot of money. His death, which he assumed was a long way off, turned out to come earlier than anticipated and his wife asked my colleague to invest the $1 million life insurance death benefit “safely” because she needed it to last for at least the next 20 years. She was told that meant she could expect to receive in the neighborhood of $40,000 to 50,000 a year. Since her husband had been making $150,000 a year, she understandably was somewhat taken aback at this. She asked if she could also dip into the $1 million and, thus, squeeze more annual income out of it. My colleague told her she could “pay down” the $1 million for 20 years and possibly get an annual income in the range of $75,000 (before tax). However, that would leave her without this source of income after 20 years (will she have saved for retirement?) and, unfortunately, by year 20 that $75,000 would feel more like $40,000 after factoring in even a 3 percent inflation rate. And, of course, there”™s the risk that the $1 million won”™t earn the return assumed and, thus, will get eaten away faster.

 

Although the client mentioned above chose $1 million in coverage simply because it struck him as a big, round number, in calculating an adequate amount of life insurance many people use a “multiple of earnings” method. While this method is simple, it also has shortcomings if multiples are too low. For example, it doesn”™t measure the non-wage value of one or both parents in running households, and it also ignores their potential for future wage increases and of inflation.

 

A better way to determine the adequacy of coverage is called “human life value.” This is the same method courts typically use to award judgments in wrongful death lawsuits. It was fundamentally the method used by the September 11th Victim Compensation Fund to compute the amount to compensate victims”™ families. While human life value can be more complex to calculate than “multiple of earnings,” it is considered a more accurate estimate of your real future value to your family.

 

An example
Human life value is defined as the present value of all future income you could expect to earn for your family”™s benefit, plus other value you expect to contribute, less taxes and personal consumption through your planned retirement date. The example below illustrates how it is calculated.

 

“April” is age 35 and plans to retire at age 55. She currently earns a salary of $50,000, of which 20 percent goes for her own personal living expenses and the other 80 percent for her family. Also, she provides an additional $15,000 per year of non-wage value to her family. (Think of this as the cost to hire a skilled domestic worker to perform her duties. It also could include fringe benefits that help her family, such as her health insurance coverage.) April”™s total value to her family at age 35 is calculated as follows:

 

80 percent of her $50,000 salary $40,000

Non-wage value $15,000

Her total value to her family at age 35 $55,000

The next step is to increase this $55,000 for income growth over the next 20 years, until she plans to retire. If you assume a 3 percent rate of annual growth, her value would reach $99,336 by age 55. The final step is to apply a “discount rate” to each year”™s projected total value, accounting for the time value of money. The discount rate converts each projected annual amount to be received in the future to a “present value” (we used 4 percent in this example). The total present value of April”™s projected value through age 55 is just over $1 million. That is the amount of life insurance protection her family needs to adequately insure against her death.

 

Although human life value is the proper and most accurate way of accessing the right amount of life insurance to own, a simple guideline may still be helpful. Life insurance companies frequently use guidelines like the one below to set amounts of life insurance that can be purchased.

 

Underwriting guideline chart

Based on the example above, April”™s salary of $50,000 would equate to $1,000,000 (20 times her salary) of life insurance coverage, which comes very close to the actual human life value calculation.

 

Joe Biegel, CFP®, J.D., works with Associated Benefit Consultants and is a financial adviser of Park Avenue Securities in Rye Brook. Reach him at JBiegel@AssociatedBenefit.com.