- What are different methods of calculating life insurance needs
- June 30, 2013
This type of method, capital preservation and capital liquidation, can be used in conjunction with the needs analysis approach or separately, as a quick calculation; if you want to do an income replacement approach on its own.
Regardless if you are using this method strictly on its own or in conjunction with a needs analysis, once the amount of income that needs to be replaced is determined, a decision must be made as to whether the pool of capital should be preserved or liquidated.
With this approach, the capital for income replacement is left intact and the beneficiaries live off the income it produces.
It optimally provides an income indefinitely as the principle, or death benefit, remains intact, which makes it fairly simple to calculate. Also, the longer the payout period, the better this method becomes.
However, this approach isn’t perfect. If the rate of return is lower than the assumed rate, the beneficiaries could run out of money prematurely. The interest rate chosen is ultimately up to you, but a conservative, realistic interest rate will have a greater chance of meeting your goals. A good guide might be the historical rate of return on U.S Treasury Bills.
Also, the amount of money needed to fund income replacement is typically greater than of other methods, as the beneficiaries live off income only rather than principle and income.
When calculating for this method, you will first need to figure out the annual income needed, either before or after tax, in which the beneficiaries will live off. Select the method that suits you the best, including your own estimate, if you wish. After figuring out this amount, you will need to divide it by the assumed after tax-rate or return that can be earned on the income replacement fund.
For example, an annual income need of $100,000 (after taxes) and an assumed after-tax rate of return on the principle (death benefit) that is presumed to be five percent, the replacement need would be $2,000,000 ($100,000 divided by five percent).
The length of time that income needs to be replaced becomes a major factor when determining the capital needed for income replacement. Typically, this method requires less money than the capital preservation method since both principal and income are used.
A method like this also comes with some negatives. The length of time that the proposed insured’s salary needs to be replaced is highly subjective as the survivor can outlive the income stream. It also requires all the factors mentioned on the worksheet and human values needs to be examined, which makes it more complex to calculate.
The first step when calculating for this method is to determine the number of years that income replacement is needed. Once this figure is determined, you will need to multiple it by the net income shortage. The next step would be to add immediate and future capital needs to determine total capital needs. The final step is to subtract existing capital from total capital needs to arrive at additional capital required.
Since the family, in the prior example, lives off income only rather than both principle and income, $2,500,000 would be needed to generate $100,000 per year using capital preservation, while only $1,562,208 would be needed using capital liquidation (assuming 4% after-tax return for both).
However, as the period of income replacement lengthens, the difference between income preservation and liquidation narrows. For instance, if we assume a 35-year income replacement need for the above example, the capital preservation value does not change while the capital liquidation value becomes $1,866,461.50.
As this example demonstrates, the capital-liquidation approach requires a lower income replacement need. However, this example assumed the income-replacement fund would be consumer over 20 years. If earnings are less than expected, the fund could be depleted sooner. Also, if the 20-year figure is based upon the spouse’s life expectancy, the spouse could live beyond that expectancy, which would leave no available money after 20 years. This points out the inherent risk of the capital-liquidation approach, while also assuming a 4% after-tax rate return.
Assumptions about rate return and life expectancy must be very conservative in order to avoid premature depletion of the fund. The capital-liquidation method may be appropriate in situations when the income-replacement period is certain or short termed. An example would be when income replacement would continue only until the children reach a specified age.
The Life Foundation offers a simple, easy-to-use life insurance needs calculator, which is accessible by clicking here.
About Tony Steuer
Noted insurance author Tony Steuer has spent over 25 years in the life insurance industry. Steuer’s leadership roles include serving on the California Department of Insurance Curriculum board and the National Financial Educator's Council Curriculum Advisory Panel as well as having served as President of the San Francisco Chapter of the American Society of CLU & ChFC, President of the leading Life Insurance Producers of Northern California, and as a board member of the San Francisco Life Underwriters Association. Mr. Steuer is the author of Questions and Answers on Life Insurance: The Life Insurance Toolbook, The Questions and Answers on Life Insurance Workbook and The Questions and Answers on Disability Insurance Workbook - the first two were awarded the “Excellence in Financial Literacy (EIFLE) Award from the Institute of Financial Literacy. Steuer holds a Chartered Life Underwriter (CLU) designation and also holds the Life and Disability Insurance Analyst License, a designation that is held by less than thirty people in California.
Questions & Answers on Life Insurance by Tony Steuer, CLU, LA, CPFFE is licensed under a Creative Commons Attribution 3.0 Unported License.