Insurance 101: Dependant’s Day
By Arnold Machel, CFP®
“Anyone who does not provide for their own relatives, and especially for their own household, he has denied the faith and is worse than an unbeliever.” (1 Tim 5:8 NIV)
Last month I wrote about a friend who died intestate, meaning without a Will. Surprisingly between the time the article was written and the time it was published we had a very high profile case of an intestate death – Prince. He died without a Will, saddling his heirs with a lot of headaches and some very high legal bills. If only the article had been out in time for Prince to read it before he passed away! It would have saved his heirs a great deal of money and frustrations.
We’re going to stick with the dying theme for now and talk a little bit about another estate planning tool – insurance. Insurance can be very complicated and has a variety of uses, but the two most common uses are 1) to ensure that loved ones are taken care of in the event of a premature death and 2) to create liquidity for an estate where additional flexibility may be needed or wanted.
Today, we’ll focus on the first application, and save a discussion of the second for next month.
Ensuring that your spouse and other dependants are looked after in the event of a premature death is something that I would put under the “must do” column. Not providing adequate provision for survivors is, quite frankly, irresponsible. We all have a tendency to think “It can’t happen to me.” But the truth is it can happen to you. It might not – I sincerely hope it doesn’t – but I’ve seen enough surprise deaths in my career to be able to say definitively, it can happen to you, so prepare for that possibility. Where a spouse or other dependents are reliant on one’s income, life insurance is a need, not a want. In fact, I would argue that in terms of priority it should come ahead of car insurance or house insurance or most other types of insurance, not behind them.
On the other hand, the purpose of life insurance should not be to provide a big windfall to the beneficiaries. Rather, it should be about recognizing that when someone passes away, their loved ones not only lose out on their relationship, but they also lose the income associated with that person. Life insurance can and should be considered a means to create a pool from which an income can be withdrawn to temporarily (or permanently) replace the lost income.
How Much is Enough?
There are two key factors involved in determining life insurance requirements: capital needs and income needs (which we ultimately capitalize). Add the two together and we have the amount needed.
Capital needs are one-time requirements. They are the easiest to figure out. Just list them and add them up. For example, let’s say that your only debt is a $525,000 mortgage on your home. You probably want to have enough insurance to cover that off. There’s your capital need.
Then there are the income needs. Let’s just say that if the mortgage above is paid off, your survivors will still need an extra income of $50,000 to survive. That’s over and above their own income.
Now the question becomes, how much does it take to replace a $50,000 income? Well, that’s going to depend on how long a time period it needs to cover, and what sort of return the pool can expect. Let’s say that your survivors only need that income for 10 years. Simple math tells us that if there was no return on the investment and no inflation you would need to start with $500,000 to cover the income needs.
But in reality it is reasonable to expect to earn something (so let’s say we want to be conservative and project only 3 per cent). We also know that every year it costs more to live, so we should increase the amount of income each year. Let’s say that we expect inflation to be 2 per cent each year, so while we’ll want $50,000 at first, we’ll want $51,000 after the first year and $52,020 after the second and so on. Based on those assumptions you would need about $465,000. For the math geeks out there, that is the net present value of 10 future cash flows of $50,000 (increasing by 2 per cent per year) using a 3 per cent discount rate.
Add that to the $525,000 capital need and we see that this person should have $990,000 in life insurance. In this example I would ask the insurance agent what the cost of an even $1 million would be. Insurers often offer a discount at certain levels, so it’s worth asking. You might end up getting the last few thousand for free.
Any good insurance agent can help you (and would welcome the chance to help you) determine the numbers for your particular circumstances. It can be complicated, so make sure that you are dealing with someone whom you trust.
Next month we’ll look at different types of insurance and why, in the later stages of life, you might want to consider purchasing insurance even though you don’t necessarily need it. But for now, if you have someone in your life that depends on you for income, make sure that you have appropriate life insurance in place.
Arnold Machel, CFP(r) lives, works and worships in the White Rock/South Surrey area. He attends Gracepoint Community Church where he serves on the Leadership Team. He is a Certified Financial Planner with IPC Investment Corporation and Visionvest Financial Planning & Services. Questions and comments can be directed to him at firstname.lastname@example.org<mailto:email@example.com> or through his website at www.visionvest.ca<http://www.visionvest.ca/>. Please note that all comments are of a general nature and should not be relied upon as individual advice. While every attempt is made to ensure accuracy, facts and figures are not guaranteed.