- How much coverage is required; and
- What type of life insurance product is best for the situation — temporary or permanent coverage?
While both questions are important, the answer to the first question usually determines the response to the second. Most of our clients need plenty of coverage, which means the use of permanent insurance — which costs significantly more than temporary insurance such as term — is off the table unless we’re fortunate enough to be working with a very wealthy family.
So how do you answer the first question? No doubt there have been interesting spreadsheets and heuristics developed but I tend to stick with a simpler approach: I work backwards.
Sitting with my clients at the whiteboard, I ask them to imagine the financial consequences of one of them dying. What would happen to the family? Initially, the surviving spouse would receive the death benefit from the life insurance policy we are now discussing. I suggest a figure I reasonably think will be adequate, for a lot of my clients that’s around $1.5 million. I explain that no taxes will be paid on that vast sum and then emphasize the speed with which that money would be delivered following notification of the death and the paperwork completion.
The next phase of the discussion involves more what if scenarios. I ask my clients what would be the first thing they’d do with that tax-free sum. Invariably they answer, “Pay off the mortgage” and I always concur with that strategy. I add that while they will face prepayment penalties with the bank, but that those penalties typically pale compared to the relief of being mortgage-free.
I then volunteer the idea of setting aside some money for their children. This meets with positive head nods as I explain how a lump sum like $50,000 per child can be made to an RESP; or an In Trust For account if they want more flexibility.
What’s left over?
With all that done, I calculate on the whiteboard how much of the insurance death benefit remains after paying off the mortgage, leaving a legacy to the children, and covering the attendant funeral costs. It’s at this point that I make a critical assumption, and suggest that if the remaining lump sum were invested to earn an average return of 5%, then the surviving spouse would have “X” dollars annually to live on.
I’m presuming they wish to keep the capital intact. If they want a higher income, then they’ll either opt for riskier investments that offer a higher return, or partially consume their capital. Either choice leaves a potential issue down the road in terms of financing their retirements. I also point out they’re mortgage free, that future financial needs of the children have been addressed, and there is potentially a diminished need for savings.
All of this leads to the poignant question: will this be enough money for you? And the answer inevitably leads us back to how much life insurance coverage is required.
This process allows me to justify why the client needs such a large amount of coverage. After all, when I first broached the topic of life insurance, the clients claimed they were loaded with coverage from a company group plan at either two or three times salary (they weren’t exactly sure which). But either way, they knew it was tons. I’ve heard the story over and over, and it’s not unusual for me recommend the clients get two to three times the coverage they thought was adequate. This is why the subject of how much life insurance coverage is required is so grossly underestimated by the clients.
In my practice, I tend to ignore consideration of employer-provided coverage and explain my rationale by asking a client these questions:
- How long have you worked at that employer;
- How many companies have you worked for over the years;
- Did they all have similar group life coverage;
- Do you expect to be working at that company when you die; and
- Would you ever like to get involved in a start-up or be an entrepreneur?
Their answers usually make it easy to advocate they take their own coverage. Individual coverage is portable — you can take it with you regardless of your present employer. And the client can take advantage of the renewable and convertible features of the term policy.
Scott and Leah are in the mid-30s and, after living together off and on for the past eight years, finally got married in 2009.
They were referred to me because they wanted a Financial Plan. The biological clock ticking and they hoped to have children right away. Scott is a successful commission based salesman earning $150,000 yearly. Leah is a schoolteacher earning $50,000. They bought a house a few years ago and have an outstanding $300,000 — their only debt. When we got to the life insurance topic they beamed and said they had it covered. Scott announced he was covered for six times salary and Leah had opted for four times salary.
I hated to prick their balloon, but I pointed out the following issues. While Scott’s income may be $150,000, it’s based off a $50,000 base salary and $100,000 of commissions. His group life coverage was actually only for six times base salary, so he only had $300,000 of coverage.
But the bigger issue is that people commonly fail to realize that hundreds of thousands of dollars of coverage is actually woefully inadequate. I asked the couple what they would do in their current situation if one of them died. They quickly saw there was barely enough to pay off the mortgage, and then it dawned on them that one very large paycheque would be missing.
Working backwards, I suggested we start with $2 million of coverage on Scott. They both gasped. I turned to Leah and asked point blank, “If a tragedy struck, what would happen to you and how would the $2 million be spent?” I kept looking at Leah and explained the amount of insurance on Scott’s life is her decision, not his, because he’ll be dead and she’s the one who has to live with the consequences. Similarly, the amount of coverage on Leah is Scott’s decision. Sure these decisions are ultimately made jointly but this is still an important concept to get across to each spouse.
As expected, they agreed the first step would be to retire the mortgage, and then either an In Trust For account or RESP for around $100,000 for any children they hoped to have. This would leave Leah with $1.6 million, which if invested with an average return of 5% would give her approximately $80,000 annually in income. What that’s a far cry from Scott’s $150,000 income, there are no mortgage payments and the investment income would be taxed more favourably than if it was straight salary.
I pointed out this didn’t include Scott’s group coverage but Leah confessed Scott wants to own his own business soon, so there’s little chance he will still be with the big company he works for now.
Turning our attention to calculating Leah’s life insurance, I got a puzzled look when I said “Let’s look at what happens with $1.5 million of coverage.” Scott would still want to pay off the mortgage and set something aside for children. Assuming those two expenses still total $400,000, there remains $1.1 million. At the same 5% assumption, Scott would have a little more than what Leah is currently earning. But Scott was not happy with the math. He pointed out that without Leah as the primary caregiver his life would change dramatically. He would have to pay for nannies and face a serious disruption to his career.
Now came time to discuss costs. I explained Leah’s coverage would be $650 and Scott’s $1,100. They both winced. I was surprised, because most people are shocked at how inexpensive term insurance is. Then I realized I’d failed to say this was an annual premium. When I corrected this oversight you could see palpable relief.
Once the pricing sunk in, they quickly agreed that $2.5 million on Scott and $2 million on Leah was a better fit based on their anticipated needs over the next ten years.
When submitting this type of application to underwriters, advisors would be doing the underwriters and themselves a favour by taking a moment on the application to explain how the amounts of insurance coverage requested were arrived at. This exercise also heightens the sense of urgency for Scott and Leah to get their wills completed and to specifically address what happens if both parents die — since their children will likely be getting more than $5 million (The need for a Staged Distribution once those kids hit 18 will be critical).
One final thought: When was the last time you delivered a death benefit cheque and the surviving spouse told you it was too much?