Life Insurance for Income Replacement: Part 2

This article is a continuation of part 1, which covers one method to calculate how much life insurance coverage is needed for income replacement. However, part 1 only considered how much insurance coverage is needed to replace income when insurance is first purchased. Of course, needs change over time, so it’s a good idea to review them on a regular basis.

In the original example, we used a $60,000, an annual raise of 2%, 20 years of income protection, and a 4.5% interest rate. We’ll keep this same example, except now we’ll look at how the coverage need varies over time. Each year the income will go up, but you also will require one year less of replacement. So next year your salary will be $61,200 and you will need 19 years of income replaced. Fortunately, it is easy to modify the formula to account for these changes (just add a t, which represents the number of years elapsed since the original calculation).

For example, after 3 years have elapsed, the amount of coverage needed for income replacement is $877,007.40 ($940,120.24 was the original amount), which is approximately 93.3% of the original amount. We expect it to go down over time, but it is not linear (meaning that it doesn’t go down by 5% per year for 20 years). Even after 10 years, the percentage is still nearly 70%. You can take a look at the table and graph below.

This pattern will vary depending on the inputs (other than income) into the formula, but generally the need for income replacement drops off relatively slowly. Other coverage requirements (e.g. debts) can increase or decrease over time, so the interactions among them should be monitored on an ongoing basis.

If you want to play around with the inputs, there is a calculator below (see if you can match the numbers in the table above). A spreadsheet is also a good option if you want to see many numbers at once.

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