Conventional Wisdom: Life Insurance

This is the fifth in a series inspired by a toy at CNNMoney. Previous installments covered housing payments, emergency funds, asset allocation, and buying your employer’s stock.

Churchyard Derek Harper - crop Using the search box just to the right here, I have discovered that in 217 posts to this blog I have used the phrase "life insurance" exactly twice. Once in an early Frugal Friday, and once in a post about annuities. Both mentions were in passing.

That may strike you as odd. In fact, it surprises me. Life insurance is a part of personal finance and certainly a likely topic for bad advice. And yet it doesn’t actually come up all that often in the media, traditional or otherwise.

It’s in the CNNMoney tool.

You need enough life insurance to replace at least five years of your salary – as much as 10 years if you have several young children or significant debts. But you might not need it at all if you have no dependents.


And I’ll give credit where credit is due: conceding that you might not need life insurance if you have no dependents is a pretty big deal for CNNMoney. (Of course,  if you type in "0" for how much insurance you have the bubble will turn red and you will fail the question, even if you are single.)

The truth is, life insurance isn’t for everybody. It’s really a specialty item for people in certain situations, not something everybody in general needs to have. (And to be clear, I’m talking about term insurance, the kind that gets your heirs a certain amount of money if you die during a specific time period. Other varieties of life insurance are hybrid investments and/or tax shelters and are another thing entirely.)

The purpose of life insurance is to take care of the people, other than yourself, who depend on your income in the event that you shuffle off this mortal coil. You may not have any such people. In fact, I’d bet that the great majority of Americans don’t. Principally, we are talking about non-adult children and to a lesser extent the non-working spouse.

The core demographic for life insurance would be the thirtysomething with two kids in grade school and not much saved for college or retirement. Younger folks without kids and older ones with either grown kids or a decent retirement kitty are not good candidates.

How much do you need? That’s not nearly as simple as the CNNMoney tool would have you believe. A multiple of income is not a particularly useful measure. What you should care about is how much it would cost to get the kids through college or the wife retired comfortably.

And I have really no idea why the tool says you need more insurance if you have significant debt. Maybe they mean that you need more insurance if your net worth is lower. That’s true. But it is important to remember that if you die with a negative net worth your heirs will not inherit your debt. If your assets are not enough to pay off what you owe, your creditors wind up holding the bag, not your kids.

This is why those pitches for life insurance to pay off debt that you sometimes see inside your credit card and mortgage bills are so outrageous. It’s not that the rates are terrible (they often are) but it’s really for the benefit of the credit card or mortgage company, not you.

Of course, working out how much your 10 year-old would need to get him through college and into the working world is inherently subjective. You could take the approach that he should be materially no worse off because you are gone. Or you might want him to be better off, to partially compensate for having to carry on without you. Or maybe a little worse off is okay, as long as he gets what he really needs. Obviously, this is a tradeoff, premiums now against possible lifestyle under unlikely circumstances.

It is, of course, possible to buy too much insurance. (But CNNMoney doesn’t think so. Type in 2000 times annual pay and you still get the "Rest Easy" thumbs up.) Crimping your current lifestyle so that your kids can live like royalty of the unspeakable happens is not a good way to show them that you love them.

[Photo: Derek Harper]

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