There are two primary reasons why people purchase life insurance.  The better of the two reasons is to provide a death benefit (i.e., some degree of financial assistance to other persons – usually family members – when the insured dies).  The other reason is to provide savings, particularly for retirement.  However, for various reasons, including the relatively high commissions that have to be paid and the limited investment choices, ordinary life insurance policies are usually not one of the better means of saving or investing.

Assuming that life insurance will be purchased just to provide a death benefit, many people do not know how to determine how much life insurance they need.  Although most people are aware that too little life insurance is not prudent, a lot of people are not aware that too much life insurance is also not wise.

An article in The Wall Street Journal (12-6-76)provides some guidelines for determining how much life insurance is necessary. The insurance specialists cited in the article said that 75% of the after-tax income before the breadwinner’s death is necessary to maintain a family’s standard of living and less than 60% of the amount of the pre-death income would seriously lower a family’s standard of living.  In contrast, the U.S. Department of Labor, on page 7 of a publication entitled Savings Fitness: A guide to Your Money and Your Financial Future, has suggested using a range of 70% to 90%, rather than 60% to 75%.

So, which of the two sources is correct? Perhaps, neither!

  • The guidelines don’t take into consideration that family spending patterns can differ considerably. Two families can have the same amount of income, but one family may spend 85% or less of their income, whereas the other family may spend 100% – or even more — of their income. Actual spending, rather than income, should be the basis for determining how much is needed to maintain a family’s standard of living.

Furthermore, a young couple beginning a family generally has a need for more life insurance than does a couple that is middle-age or older, whose children are already living on their own, especially if the older couple has been prudently saving and investing over the years.

A. L. Williams, who founded an insurance company bearing his name, says on page 24 of a pamphlet entitled Common Sense,

The most common misconception about life insurance is that it is a permanent need that each family has.  This is totally untrue!  Life insurance is a way to buy time until you get your personal financial estate in order.  You need more coverage when you’re young, less when you’re older.

  • The guidelines given by the previously cited specialists and the U.S. Department of Labor also do not take into consideration subsequent inflation. The higher the rate of future inflation, the greater the amount of income that will be necessary for each subsequent year. Therefore, it is important to reassess every few years the amount of life insurance that your family needs, taking into consideration changes in your family’s cost of living.

The following approach to determining how much life insurance is prudent for your family should be more helpful than using the previously mentioned guidelines that are based on percentages of income:

  1. Calculate your family’s normal living expenses (i.e., how much is necessary to maintain your family’s standard of living), and adjust for any known or probable changesFor this example, assume that you expect your family’s living expenses to be about $40,000 annually.
  1. Determine how much annual income your family would receive from sources other than your life insurance benefits. These sources would include wages earned by your spouse, social security benefits your spouse would receive, pension benefits and annuities to which your spouse would be entitled, and any other regular income your spouse could expect, but do not include any income from savings and investments.  (Income from savings and investments will be taken into consideration in a subsequent step.)  For this example, assume that you expect your family to have regular annual income of $25,000.
  1. Subtract the amount in step #2 from the amount in step #1. The result is $15,000 ($40,000 – $25,000).
  1. For this example, assume that you expect your spouse to live to the age of 90, and subtract his or her current age from 90. Thus, if your spouse is currently 35 years of age, the result is 55 (90 – 35).
  1. Choose what you think is an appropriate investment rate factor from the following table.
     Years Until Spouse      Reaches Age of  90

Investment Rate Factor

Conservative More Aggressive
25 20 16
30 22 17
35 25 19
40 27 20
45 30 21
50 31 21
55 33 22
60 35 23

Source: Bailard, Biehl & Kaiser Inc., as reported in The Wall Street Journal

Using the figure of 55 derived in step #4, the investment rate factor would be 33, if you want to be conservative in your assumption regarding the rate of return that your family will earn on investments.  If you would prefer to be more aggressive in your assumption, then a factor of 22 may be used.  Assume for this example that you want to be conservative, so the factor is 33.

6.  Multiply the result in step #3 by the factor of 33 derived in step #5. The result is $495,000 ($15,000 x 33).

7. You may want enough insurance to also pay your funeral costs, to pay off debts you still owe at the time of your death (possibly, including the mortgage), and/or to provide for anticipated costs of a college education for each of your children.  For this example, assume that the additional desired amount determined by this step is $95,000.

8.  Add the amounts from steps #6 and #7. The result is $590,000 ($495,000 + $95,000).

9.   Show the current total amount of your family’s savings and investments.  Assume for this example that the amount is $40,000.

10. Subtract the amount in step #9 from the amount in step #8. The result is $550,000 ($590,000 – $40,000).  This is the estimated total amount of life insurance that is currently needed for the primary wage-earner in this example.

Consideration should be given to having life insurance on your wife, as well as on yourself, even if your wife does not have a regular income-producing job.  This is especially true if your wife were to die and you need to pay for daycare for your young or handicapped children.

Whenever there is a significant change in your family’s circumstances, but at least every five years, repeat steps #1 through #11.  Significant changes in circumstances include having a new child, experiencing a significant increase or decrease in your family’s cost of living, and/or undergoing a substantial increase or decrease in the total amount of your family’s savings and investments.