In the final month of our focus on risk management, I am going to pick on a pet peeve of mine from the life insurance sector. I continue to see life insurance needs analysis done like so:
- Samantha earns $100,000 per year, or $72,000 net of taxes.
- Derek, her spouse, earns $80,000 per year, or $60,000 net of taxes.
- They would be retiring in approximately 30 years.
- Their household spending, not including their mortgage, is $110,000, requiring $110,000 of after-tax income.
- Their mortgage and other debts total $500,000.
I see a lot of students do this needs analysis:
- Lump sum needs of $500,000. The mortgage is paid off; no need for ongoing mortgage payments. All good. No issue here.
- $50,000 for final expenses. All good. No concerns.
- Annual projected shortfall of $50,000, based on Derek continuing to earn $60,000 but household expenses running at $110,000. There might be some question about whether expenses continue at that level, but let’s assume they do. We could (and should) do a lot of work here to make sure we’ve properly prepared Derek in the event of Samantha’s premature death. What I often see here is a needs analysis of 30 years x $50,000 annual shortfall, or a $1,500,000 need.
- The total need, then, is $1,500,000 (ongoing survivor needs) + $500,000 (debts) + $50,000 (final expenses) = $2,050,000.
Why not take into account that Derek, upon receiving a substantial lump sum, would be able to invest that and earn a return? This is very similar to a retirement needs analysis. I would never say that somebody with a 30-year retirement time horizon and a $50,000 annual need should have a $1,500,000 portfolio. Instead, we would account for a rate of return. A needs analysis here might look like so:
- 30 year time horizon.
- Assumed rate of return, net of fees, of 3.3%. This is based on a somewhat conservative portfolio of 50% equities, as indicated on page 19 of the 2022 FP Canada Projection Assumption Guidelines. This portfolio does have to have at least some cash and fixed income, because it is being used to sustain annual spending.
- Assumed inflation of 2.1%, resulting in a real rate of return of 1.2%.
- This will be a non-registered portfolio; we can also assume an effective tax rate of 15% on investment income, bringing this return down to 1.02%.
- Annual need of $50,000.
- The Present Value of this need is $1,286,623.
Using conservative projections, we have reduced Samantha’s insurance need by $213,377. That will reduce her needed premiums. Those premium dollars can be allocated to any other need, such as retirement savings, disability insurance, or a family vacation.
Some readers might say, “But nobody ever complained about getting too large a death benefit.” Fine, and we should do a proper needs analysis. To borrow from insurance icon Jim Ruta, we can do a wants analysis. Maybe Samantha and Derek agree that an extra $200,000 of life insurance would be used for Derek to take a couple years off work, for example. And that’s great. But that should be an informed decision by the client. We shouldn’t be relying on inadequate math as a substitute for a proper needs analysis.
If you’re concerned about how to do this math, Excel or Google Sheets makes this easy. Here is a sample needs analysis:
Even an Excel novice can build this. You just need to type in the annual need, rate of return, and years of need. Then you can use the formula =PV(B2,B3,-B1,0) (just copy and paste it into Excel or Sheets) in Cell B4 and you’ll have your own accurate life insurance needs analysis tool.
Thanks so much for reading! I would love to hear your comments about tools you’ve found useful (or not!) in doing needs analysis for clients.
Last month we discussed Risk Management and Financial Planning, you can read that here.
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