The last couple of weeks, I have talked about life insurance, which is one of the cornerstones of financial planning. To summarize, you need to know how much you need, what kind to buy and who to buy it from.
In this article, I want to tell you about Cathy and her needs for life insurance. Cathy is a 45-year old single mother of 5 children. The kids range in age from 7 to 22 and are all currently living at home, dependent on their mother. Cathy is raising these five children on a total income of about $40,000. In the words of Cathy, “My life is about kids, kids and should I say kids.”
The decision to buy life insurance
A few years ago, Cathy took on a sacrifice. Although she was living day to day on every paycheck, she decided that she needed to put some life insurance in place to make sure that the kids would be taken care of in case of her death. She met a life insurance agent and after a couple of discussions, it was recommended that she buy $200,000 of permanent life insurance for $120 per month. As much as Cathy was not sure where she would find $120 per month, she knew that life insurance was an absolute necessity.
Personally, I cannot imagine what it takes to raise five children as a single parent on $40,000 per year and then having to sacrifice $120 per month when every single penny counts. The question is did Cathy do the right thing?
Did Cathy get the right amount of insurance?
Without question, Cathy did the right thing and put some life insurance in place. However, if you do the analysis, she did not buy enough life insurance. While it makes sense that she could not afford to spend more that $120 per month on additional life insurance, it is easy to see that $200,000 of life insurance would not last too long to support 5 children.
How much life insurance does Cathy need? The first thing we need to look at is insuring against the debts. The only debt Cathy has is her mortgage. She has about $50,000 outstanding. The next thing to look at is income replacement. On an after tax basis, Cathy is earning about $30,000 per year. In order to replace $30,000 per year, she will need about $500,000. The last thing to consider is whether she would like to have some extra money to cover final expenses like legal costs and funeral expenses.
There is no perfect number, but if you take into account that Cathy has some assets to cover these needs, Cathy needs about $500,000 of life insurance coverage. With only $200,000 of life insurance, Cathy would be considered underinsured.
What kind of insurance should Cathy have?
For $120 per month, Cathy is paying for a Universal Life insurance plan. As long as Cathy keeps paying the $120 per month, she will never outlive life insurance. Her premiums will never go up. The issue is that at some point in time (ten years), when the kids grow to independence, Cathy may not need life insurance. The issue is that she is currently uninsured and may be over insured in the future.
For Cathy, we took a look at what it would cost to buy lower cost term insurance instead of more expensive permanent insurance. For $500,000 of ten-year term insurance, it would cost her $50 per month, more than twice the insurance for 40% of the cost.
I use this real life example to illustrate some key points when you are making the decision to buy life insurance:
- This is clearly a case where the wrong type of insurance and the wrong amount of insurance was put in place. For less money, Cathy was able to get a lot more insurance. Although term insurance is more temporary in nature, the fact is the primary need is also temporary.
- Cathy's intentions were in the right place. However, this is a clear example of someone who is paying too much for the wrong type of insurance. After we made some changes to put term insurance into place, Cathy was able have the peace of mind that she had the right amount of insurance for her kids to survive on. With the monthly savings, she could afford to put in place some disability insurance and even contribute monthly to an RRSP.
- Every life insurance plan needs to be reviewed from time to time. Life changes, assumptions can change and certainly personal needs change. For Cathy a review made a significant difference to her future.
- Start with determining if you need insurance and only buy insurance if you need it. Then, determine the right amount of life insurance before you decide what type of life insurance to buy. Finally, shop around, as there are different products and different costs. Make sure you buy the type of plan that best suits your needs.