Life Insurance for Income Replacement: Part 1
As we wrote in our article on how much life insurance coverage you need, one of the critical items to assess is the amount of life insurance coverage needed for income replacement. There are many rules of thumb (e.g. a multiple of your annual income, such as 10 or 15), but it is better to be more precise. We’ll cover one possible method in this article, which is the first of two parts (part 2 here).
In this approach, the death benefit is equated to the present value of your future earnings (i.e. the value of all your future earnings in today’s dollars). The inputs that we’ll need are the current level of income, the annual increase in income, the number of years of income to replace, and an interest rate. Once we have those, we can just plug numbers into a formula:
I won’t go over how the formula is derived, although it isn’t too difficult. In this case, we’re assuming that you get paid once per month and the end of every month. The variable i is the annual effective interest rate, n is the number of years of income to replace, and r is the annual growth rate in your income (r and i should not be equal when using this formula).
So, if you make $60,000 per year, expect your income to go up 2% per year, want to protect 20 years of income, and assume a 4.5% interest rate, you should come up with $940,120.24 (which in this case is 15.67 times your annual income). Another way to think about this is that it is the amount that if it were invested, always earned 4.5%, and you always took out the exact amount of projected income at the appropriate times, you would end up with zero in the account at the end of 20 years.
The table below shows the value from the example as well as the values for different interest rates and years of income replacement. If you want to change the starting income from $60,000, you can take the numbers in the table and divide them by $60,000 and then multiply them by the desired starting income (e.g. for $120,000 all the values in the table would double). The income growth is fixed at 2% per year, so if you want to play around with all of the inputs, it’s probably easiest to use the calculator below (you should be able to match values from the calculator to those in the table below). You could also make a spreadsheet if you want see a lot of numbers at once.
Another thing to consider, which we cover in part 2, is how this income replacement amount changes over time.