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.

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]

Media | Frank Curmudgeon | November 17, 2009 1:09 pm

250 Comments

By kosmo @ The Casual Observer, November 17, 2009 @ 1:20 pm

My wife once made a comment that she was concerned that our term policies aren’t renewable beyond age 80ish.

My response: Life insurance is income replacement. I hope I don’t have considerable income (from wages) at age 80 …
By Steve, November 17, 2009 @ 2:45 pm

Maybe I’m just suffering from the “everyone’s like me” fallacy, but it seems to me that the majority of people will go through the “thirty something with one or more kids” phase at some point in their life. (Which is not the same as the majority being in that situation right now.) And I also suspect that the majority of people fall into the category of “insufficient net worth to replace their own income if they died” up until they are almost retired (otherwise, they would retire!) So for the vast majority of Americans, basically the rule boils down to “has at least one child between the ages of conceived and graduated from college.”
By CalLadyQED, November 17, 2009 @ 2:52 pm

I noticed that the CNN Money Tool didn’t like me putting in $15k, even though it was essentially recommending that I have $0.

At my job, we are required to pay for life insurance. Since I’m single and childless, I chose the lowest option. I don’t worry too much about having to pay for insurance I seemingly don’t need because I actually take comfort in knowing that I’m able to at least partially cover burial, funeral, medical, legal, etc. expenses that may be incurred in the course of my death. I’m glad that I can easily cover the potential financial burden my parents and/or siblings may face.

You can buy life insurance specifically to pay for burial or you can buy regular life insurance and tell you heirs that’s what it’s for. I think this would be very important to even the young and dependent-less, if one has particular ideas about burial. For example, many people are adamantly against cremation, but that is much cheaper than traditional burial. Providing the funds for burial may help get your wishes carried out. As another example, my grandmother wanted an autopsy, but after she passed, there wasn’t any money set aside for that, so it almost didn’t get done.
By CalLadyQED, November 17, 2009 @ 2:53 pm

Okay, not recommending $0, but suggesting $0.
By Ryan, November 17, 2009 @ 3:09 pm

I have about $1M term coverage, and $500k for my wife. We have two young kids.
By Evan, November 17, 2009 @ 3:09 pm

“And I have really no idea why the tool says you need more insurance if you have significant debt”

Its because most life insurance calculators (I haven’t toyed around with CNNs) assume paying off those debts at your death. So if your mortgage is $500K – it would essentially pay that off so your surviving spouse wouldn’t have to.

Also I never understood the 10x income vs. 10x or 20x what you need to live! Similarly I think a lot of people/calcs overestimate their ability to work upon the loss of a spouse with 2 or 3 kids at home.
By Tyler, November 17, 2009 @ 4:00 pm

I don’t think that my significant other has ever had the urge to murder me, but I think 2000x my salary would make her at least think about it…
By Ron, November 17, 2009 @ 11:37 pm

Life insurance has more uses than to just provide for your loved ones. Some use it to pay their death taxes, still others believe it’s morally wrong to leave outstanding debt. Others realize that there may be medical bills left unpaid and life insurance can handle that. I’ve had life insurance on myself since I was 19 years old because I realized that a funeral and other final expenses would be costly and I didn’t want my parents to foot that bill. Today I carry almost $2 million in life insurance. Cost: $78/month. Benefit: My wife (who is a stay at home mom) wouldn’t have to stop homeschooling my kids to find a job and the interest on $2 million really doesn’t provide much more than an average income by today’s standards (assuming 5%). Remember, she still has to retire herself — and pay for 3 college educations, 2 weddings, and God only knows what else.
By Allan, November 18, 2009 @ 10:33 am

I really like this blog overall, but I disagree pretty strongly here. Why does the popular advice for life insurance always try to boil down to how much coverage would cover the essential “needs” of the spouse or kids? Other insurance isn’t bought that way. Nobody who drives a BMW buys only enough car insurance to replace it with a KIA if he crashes it. Nobody who lives in a $600K home would be OK with the insurance company rebuilding a $300K home in its place if it burned down. This is exactly the kind of thinking we do when we try to solve for “needs.” The purpose of insurance is to idemnify the loss of an asset. Life insurance is no different. It should be bought with the intention to absorb as much of the loss of future earnings of the insured as possible. As for the idea that you can buy too much insurance, this is difficult to do, as the insurance company normally will not allow someone to buy more coverage than their economic life value would justify.
By Neil, November 18, 2009 @ 11:48 am

My wife and I both work and have reasonably equal incomes. (She currently makes slightly more…I’ve had an informal offer that I’m waiting for in writing that should flip that). But we still found we need life insurance.

The exact number we worked out was “enough to pay funeral costs, and eliminate all debt including mortgage.” Almost half of our after-tax income goes to debt payments, you see, so eliminating that would leave one person with a similar, even better, lifestyle on just the one income.

But yes, incredibly situation dependent, and I wouldn’t want to suggest anything resembling a rule-of-thumb for it.
By Neil, November 18, 2009 @ 12:07 pm

On further thought, I realised that “you need more insurance if you have significant debt” is just plain wrong. The purpose of life insurance is largely to replace your own income should you pass on. Usually the 20x recommendation is predicated on putting the payout into CDs that yield around 5% (ignore for now that these don’t currently exist).

But invariably debt interest is higher than savings interest, so if you are replacing your income in the form of reduced debt payments, it actually takes less money to achieve the same effect.

Plus you don’t pay taxes on reduced payments…you do pay taxes on interest revenue.
By Monevator, November 18, 2009 @ 12:09 pm

I’ve no spouse and no dependents and have been told more than once that I need life insurance by people who haven’t thought it through.

Who gets the money – my dog?!
By Holly, November 19, 2009 @ 12:30 pm

Try to think about the big picture…as a stay-at-home mom without any real personal income for the last ten years…let’s say my husband passes (he’s a police officer) – First, the grief would be tremendous all around. Then, life must go on; how easy would it be for me to replace his $100,000+ salary? How easy would it be for me to make the mortgage payments without emptying the retirement funds (not built up to where they should be–yet); no more Catholic education for three kids. Burials can cost over $25,000. I would only receive a percentage of his pension and no SS since he doesn’t pay into it (and neither have I). GET IT??? Even my 65 year-old retired father has $25,000 worth of life ins. (free through previous employer) because if, by chance, he passed away along with his wife, even though they have savings, most of that might be gone at that point (they travel a lot). The life insurance benefit would help to offset the funeral costs for me and for my sister. It’s about thinking of those other than yourself.
By Alexandra, November 19, 2009 @ 2:52 pm

I agree that life insurance should only be purchased for those who have dependants.

But some people do have personal desires that they wish to fulfill through the money a life insurance policy would produce. Some people want to clear their debt post-humously. No, it isn’t required, it’s just what they want. Some people want to cover their funeral costs. Life insurance is a pretty personal thing I guess.

My husband and I each have a million or so. Not enough to kill him for though – he is worth more to me alive than dead .