We are fortunate enough to live under ten minutes from my parents.
So, when we tell them we'll be there at 2:00, we usually start getting ready around 1:45.
We always end up being more than a few minutes late.
Issues with the kids getting their shoes on or going to the bathroom. Meltdowns when the TV/iPads go off. The need to suddenly find (and bring) a toy that hasn't been seen or played with in 18 months.
As humans, we often underestimate our needs and fail to consider other factors.
It's a phenomenon known as the Planning Fallacy, defined as "the tendency to underestimate the amount of time needed to complete a future task, due in part to the reliance on overly optimistic performance scenarios."
We don't just underestimate time. We also underestimate the distance needed to clear the water when we golf and the amount of money it will take to renovate a bathroom.
It also happens when it comes to life insurance.
When discussing insurance with clients, I'll ask them how much insurance they think they need. It often amounts to a round number of sorts.
When pressed on how they came up with that number, it's usually something along the lines of "it sounded about right."
The number also tends to be on the low side.
This makes sense, given that the Planning Fallacy says that we tend to focus on 'overly optimistic scenarios.' People tend to think they're going to live for a very long time and won't need much insurance.
There's also a tendency from people to think that an insurance number is "too high."
Take $1,000,000 of coverage for example. If I wrote you a cheque for $1,000,000 today (note: I am not able to do this), it certainly seems like a lot of money, especially if you have a household income of $250,000.
This scenario completely changes if one member of the family passes away and their income disappears. Add in a large mortgage, children's education, income loss of the surviving spouse during the grieving period (as examples) and that amount suddenly doesn't seem as significant as before.
If you get the arrival time to the grandparents wrong, it's not the end of the world.
Get your life insurance number wrong and it could be bad news for your dependents.
Let's examine how you can best determine the correct amount of life insurance for you and your family.
NEEDS TO CONSIDER
When looking at the amount of life insurance to get, it's essential to "crash test" your life and consider your capital needs.
These include, but are not limited to, the following financial obligations:
- The amount remaining on your mortgage, as well as other debts
- The amount of lost income you wish to replace
- Additional child-care costs or income loss of surviving spouse during the grieving period
- Final expenses
- Child's education
- Charitable donations
- Tax obligations surrounding registered investments (RRSP, LIRA)
Now that you know what you'd like to insure against, let's break down a few standard methods of calculating how much life insurance you need.
Salary Multiple (or the 10x rule)
This is the most basic calculation. It involves a multiple of your current income to determine your life insurance need. What that multiple should be varies, depending on the source. It ranges from 5x to 20x your annual salary. Most often, that multiple is 10x.
Following this formula, if you make $75,000 a year, you would need $750,000 of life insurance.
While this is an easy formula to understand, it does have its downsides.
Someone making $75,000 a year with no kids and no mortgage has vastly different insurance needs than the individual making $75,000 with an $800,000 mortgage and three kids under 5.
An acronym for Debt, Income, Mortgage, and Education, the DIME formula has you add your expenses in each category to come up with your life insurance amount.
To calculate, take your existing debts and add them to your annual income (multiplied by the number of years you'd like to replace it). From there, add the remaining balance on your mortgage and an estimate of what your future education costs might be.
This gives a far more precise calculation of your actual insurance needs than the salary multiple method.
You can take it one step further (best done with the help of an insurance expert) and do a full-blown insurance needs analysis. The expert will take the calculation from the DIME formula and consider the existing life insurance (individual and group) policies that you currently have in force, as well as any assets (RRSPs, TFSAs, real estate) that you might wish to liquidate upon death.[MK1]
One important point to note: these formulas tell you what your needs are today. It's often best, however, to project your needs 5-10 years from now.
When applying for life insurance, you will have to complete a health questionnaire and a full medical underwriting by the insurance company. If you need to add life insurance down the road, you will have to undergo the same underwriting process for the additional amount.
Your health changes, as does your insurability. As a result, there's always a chance that your application for additional insurance is rated (meaning higher premiums) or declined.
So, if you know that you'll be having more children or moving to a bigger house (with a bigger mortgage) down the road, consider that in your original calculations.
In the end, while you can do this yourself, it is advisable to seek the guidance of an insurance expert. They will take your overall financial situation into account and complete a full needs analysis for you.
In our next article, we will begin to examine Disability Insurance.
Please join us.