Life Insurance for Dummies
Once you’ve decided it’s time to act like a grownup with regard to personal finances, you start worrying about things like life insurance. Should I have it? Do I buy it? What kind do I buy? How much do I buy? Gaaah. This is why I like to keep my head in the sand, Anna!
Listen, life insurance sounds a lot scarier and complicated than it actually is. I suspect it’s because of the association it has with death. The reality is, life insurance should not be terribly expensive, nor should it be complicated, or difficult to get (unless you already have a terminal illness or are an X-games participant), provided you do it now, when you are young and healthy. Or nearly so.
First let’s talk about what the purpose of life insurance is, so that everyone is clear. Life insurance is meant to replace your income, should something happen to you, for your dependents. It is like attaching a monetary value to your physical being, as distasteful as that sounds. So, knowing this, when you think about life insurance, you only have to think about this one question: who is dependent upon me for their food, clothing, shelter, well-being? Who will lose their livlihood along with me, should I die?
Substantial life insurance is only necessary for people who have dependents, since only people with dependents are responsible for the financial well being of others. Persons with dependents should buy a 15-year term life insurance policy in an amount equal to approximately ten times their annual income.
What does this mean? Well, it means that if you are single, there is no reason for you to buy more than about $10,000 in life insurance, or the rough equivalent of what it will cost to bury you if you die. If you want to stick it to the man, or to your parents, or whomever, then don’t even buy that much. A lot of times people will be offered life insurance plans at work, and even though they are single, they will buy in and name a distant relative as the beneficiary. Listen, if you’re getting your life insurance for free, then go ahead and take advantage of it, even if your single. But if they ask for contributions, only contribute enough to cover the cost of funeral arrangements for yourself in the event of your untimely death. Any more than that is a waste of money.
If you are married and/or have children, then you need to think about what amount of income will be lost in the event of your death. A good estimate for this number is 10 times your annual income. Why ten times? Because the ideal situation would leave your dependents with enough principal to take out the rough equivalent of your income each year in interest–i.e. if you die and your wife is left with $1 million, then she can invest it in a decent mutual fund and take out approximately $100,000 a year from the interest (this math doesn’t work as nicely when the stock market is in the shitter, but we will talk about more conservative investments on another day). If you want to plan for even worse scenarios, then you can do twelve times or 15 times. But I think if you use the number 10, in most economies, your beneficiaries will be a-OK.
Now, say you’re married with a child, and you don’t work outside of the home. Do you need life insurance in this case? Yes. You need enough life insurance to cover what it would cost to hire somebody to care for your children while your widowed spouse is out working. So figure out what that would be, and again multiply it by ten, which should at the very least get your kids through the early years and into school.
But what kind of life insurance do I buy?
In almost all cases, you should buy a term life insurance policy for ten, fifteen, or thirty years. The exact length of the policy is dependent upon your age–if you are 20, then buy as many years as you can. If you are older than that, then you can buy a little less–it’s up to you. If you are young and healthy, you should have no problem obtaining this kind of policy for shockingly low numbers. If you are not so young or not so healthy, it might cost more. If you have serious health problems, then you will have to get a whole life policy in all likelihood, because they won’t insure you otherwise. But you should always, always try to get the term life policy first.
But my insurance agent told me about a policy that functions as a savings plan. It is called “whole life” or “cash value.” Shouldn’t I use that?
No. The whole life “savings” plans are really a giant rip-off. They allow you to cash out early from a plan, which works out to be s spectacularly low interest rate, if you make any money at all. What they will do is ask you to pay $100 a month towards a life insurance plan, whereas a term life policy will cost much less (proportionately). Then they will show you how they invest this money and make lots of money. Unfortunately, these investments rarely work out as planned. Please cf. the AIG debacle if you are unsure about this. Wouldn’t you rather pay less now and put the difference in a smart investment *of your own choosing,* rather than trust a giant insurance conglomorate to invest it? Particularly when their current income generating policy is to ask the government for a bailout?
The main thing with life insurance is to not be afraid of it. Just call up an agent and get it done, and stop thinking about it. Once your policy is in place, you can just pay your premiums and forget about it while you get the rest of your financial picture in place. In all likelihood, the only place you’ll ever need to see the damn policy is in your filing cabinet.