You buy life insurance to provide for your dependents when you’re no longer around to do so. Since none of us comes with an expiration date and since life by its very nature is all about change, it can be tough to accurately predict your family’s financial needs years from now.
The answer to the question depends on several factors, including:
• Your age.
• The ages of your spouse and children.
• Your income.
• Your mortgage and other debts.
• College expenses for your children and/or spouse.
• The size of the last bill you’ll ever incur: your funeral expenses.
To address this guessing game, insurance companies and financial planners have devised models to help you zero in on this perpetually moving target. Three approaches are most common:
• Multiple of income: This industry standard recommends that the death benefit, or payout amount, of your life insurance policy should be seven to 10 times your annual income.
• Shortfall calculation: The shortfall approach works backward from the annual income you would want to leave your spouse and family for X number of years. After you decide on this target number, you then subtract all other sources of annual income that will be available to them, such as your retirement accounts, pension, savings, your spouse’s salary and Social Security. The resulting number is the shortfall you’ll want to replace with life insurance.
• Income generator: Some prefer to set their sights on building up a large life insurance investment that would generate earnings to provide a beneficiary with annual income. For instance, $1 million invested using a conservative average annual yield of 4 percent could provide $40,000 a year to a spouse or family in perpetuity.