Life Insurance Needs: Income Replacement Approach
What is the income replacement approach?
The income replacement approach is a method of determining the
amount of life insurance you should purchase. It assumes that the goal of life
insurance is to replace the lost earnings of a family breadwinner who has died.
Under this approach, the insurance purchased is based on the value of the
income the insured breadwinner can expect to earn during his or her lifetime.
By focusing only on a family breadwinner's expected future earnings
stream, the human life value provides a fairly rough estimate of life insurance
needs. To help make your insurance needs estimate more accurate, the income
replacement approach allows for some adjustments to the human life value.
Determining the insured breadwinner's human life value
Calculating the human life value, or the present
value of the expected future income stream, is the biggest component of
the income replacement approach. In fact, this calculation alone sometimes serves
as the income replacement estimate. The human life value calculation has
several components:
Start with the insured breadwinner's after-tax earnings
The first step is to take the insured's current after-tax earnings.
The major piece of after-tax earnings is after-tax salary. You use after-tax
rather than gross earnings because it represents the amount actually available
to spend on your family's needs.
Example(s): If the insured's gross salary is
currently $60,000 and the federal and state combined income tax liability is 35
percent of her gross salary, her after-tax salary is $39,000. This figure
represents the amount the insured currently provides for the family.
Subtract out the percent of income the breadwinner
devotes to personal expenses
In defining human life value, many financial planners include only
that portion of the anticipated future income stream that would be devoted to
the family. Since a part of the insured breadwinner's earnings go to
self-maintenance (e.g., clothing, food, and individual transportation
expenses), that part of the future income stream has no bearing on supporting
the family. The frequent assumption is that 25 percent of after-tax income goes
for the breadwinner's personal expenses and the remaining 75 percent goes for
family living expenses. You can, thus, multiply the expected total earnings
stream by a family support ratio of 75 percent
or some other amount to reflect the percentage of income that actually supports
the family.
Example(s): The insured earns a $60,000 gross
salary and $39,000 after taxes. To roughly subtract out the percentage of
income devoted to personal expenses, you can multiply $39,000 by the general
average 75 percent family support ratio to get $29,250 for the after-tax amount
actually devoted to family support. If you have a more precise figure, say 30
percent, for the amount the insured actually spends on him or herself, you can
use a 70 percent family support ratio instead. You then come up with a $27,300
($39,000 x 0.70) figure for after-tax income supporting the family.
Consider adding employer retirement
plan contributions to the after-tax earnings figure
After-tax earnings also include contributions by the insured's
employer to a 401(k) or other retirement plan. These contributions are an
income source that will cease upon the insured's death, just as salary payments
will cease. Although they don't go directly toward family expenses, they can
help ease the surviving spouse's retirement saving needs. Therefore, you also
may want to add in the employer's annual retirement plan contribution to get a
more accurate figure for the anticipated after-tax earnings.
Example(s): Assume once again that the
insured's gross salary is currently $60,000. Also, assume that he or she
participates in the employer's 401(k) plan. Under the plan, the employer
matches employee contributions at a rate of 50 percent. If the insured
contributes 6 percent of income to the plan, or $3,600, then the employer
contributes an additional 3 percent, or $1,800, to the insured's retirement
account. You should add this latter $1,800 amount to the after-tax salary
figure.
Figure the number of years of income
you need to replace
The future earnings stream you want to protect reflects the income
the insured will earn over the number of future years he or she expects to work
until retirement.
Example(s): The insured is 40 years old and
anticipates retiring at age 65. His or her expected future economic life is 25
years. The lost income stream if the insured died today would be for 25 years.
Take into account anticipated salary
growth and inflation
It is unlikely that the insured's earnings will stay the same over
time. They will probably increase due to several factors: inflation and merit
increases, promotions, or other salary growth separate from inflation. You,
therefore, need to factor in an earnings growth factor to account for these
effects on the future earnings stream. The growth factor is the sum of the
effects.
To account for inflation, you have several choices for the
appropriate figure to use. You can choose the long-term average inflation rate
of approximately 3 percent, which also roughly reflects recent inflation
trends. If you think that figure is overly optimistic for the future, you can
instead choose the approximately 5 percent average inflation rate of the 1980s
or the approximately 7 percent average inflation rate of the 1970s, for
instance. To address anticipated salary increases that are unrelated to general
inflation, you might use the 2 percent figure for the average annual
inflation-adjusted, after-tax salary increase across all industries. If the
insured is in a particular industry with much higher or lower annual increases,
you might instead use that industry's annual average increase.
Tip: If your family's desire is to
maintain its current standard of living in the event the insured dies, then
accounting for future raises above inflation is unnecessary. You can simplify
matters by just using a future inflation rate estimate for the growth factor.
Example(s): The insured works in a
computer-related field. You are concerned that current low inflation rates may
not hold into the future. You might, thus, choose a 5 percent inflation factor
instead of the lower 3 percent long-term average. The insured's computer field
offers annual salary increases above the average 2 percent inflation-adjusted
rate across all industries. As a result, you might use the particular field's
average 4 percent inflation-adjusted salary increases as opposed to the
cross-industry average. Your growth factor would be 9 percent (5% + 4%). Note
that if your family's goal was just to maintain the current standard of living
and not account for future merit, seniority, or other increases unrelated to
inflation, you would just use the 5 percent inflation factor as the growth
factor.
Determine the total anticipated future
income for supporting the family
You can calculate the expected future income stream using the
following figures:
• Current after-tax earnings (which you
can multiply by the family support ratio)
• Number of years the insured expects to
work
• Earnings growth factor (accounting for
inflation and salary raises)
This income stream represents the future value, which you then need
to discount in order to arrive at the present value,
or the human life value.
Determine a discount rate for the
insurance proceeds and calculate the present value
You need to determine a discount rate that reflects the after-tax
investment return on the insurance proceeds over the years. The investment of
the life insurance proceeds should provide returns over time that equal the
income stream calculated in the previous step. Stocks, bonds, Treasury bills, and
other types of investments offer varying average rates of return. Figures are
available for short-, medium-, and long-term average rates of return for the
different types of investments. Stocks generally offer the highest rates of
return, and significant variations exist among the different types of stock.
Similarly, different types of bonds offer different average rates of return.
Tip: Many financial advisors recommend
using relatively conservative investment returns for your discount rate. This
way, you account for possible market declines or lower-than-expected rates of
return on your investments.
Caution: Avoid basing your discount rates
on the unusually high rates of return for investments during the 1990s. These
rates of return don't reflect the long-term trends and most likely won't
reflect long-term future trends.
You complete the human life value calculation by determining the
present value of the expected income stream, using the discount rate you have
selected. You can utilize either a formula for calculating present value or the
easier-to-use present value tables. If you use present value tables, they
typically give the present value of $1 at various rates of return for different
numbers of years that you invest. You simply take the number of years and
percentage that apply to you, find the present value in the table, and multiply
it by the expected income stream figure you determined above.
Example(s): Assume you calculated an expected
income stream of $800,000 for a 25-year period and have chosen an
inflation-adjusted discount rate of 4 percent. You turn to the present value of
$1 table and find a figure of 0.375 for a 25-year investment at 4 percent. You
then multiply $800,000 by 0.375 to come up with a human life value of $300,000.
Making adjustments to the human life value
As mentioned, the human life value isn't a very precise estimate of
your family's actual life insurance needs. In one sense, it tends to overstate
your family's insurance needs by failing to account for other family assets and
sources of income that can help support the family if the insured dies.
Investments, savings accounts, and Social Security survivor benefits, among
other things, can offset some of your family's life insurance needs. In another
sense, it tends to understate your family's life insurance needs by failing to
account for certain large lump-sum expenses that will come up only after the
insured's death, such as final medical expenses, funeral and burial costs,
estate settlement expenses, mortgage and other debt repayment costs, and
college education costs. The income replacement approach allows adjustments for
these factors, so you arrive at a more precise insurance needs estimate
tailored more closely to your family's circumstances.
Subtract out other assets and sources
of income
In reality, your family probably won't need to depend entirely on
life insurance to replace the insured breadwinner's lost income. It may have
investments in stocks, bonds, or other assets. It may have savings accounts or
certificates of deposit. In addition, the surviving spouse and eligible
children will qualify to receive Social Security survivor benefits over time.
To make a proper deduction for a stream of these benefits, you will need to
calculate their present value. With the income replacement approach, you can
subtract these additional sources.
Add in large lump-sum expenses
Projecting an income stream based on your family's current standard
of living doesn't provide for large lump-sum expenses that will occur only in
the future. First, the insured's death will result in final death expenses,
including final medical costs, funeral costs, and estate administration costs.
Second, the insured's death may necessitate paying off personal debts, such as
credit card debts, college loan debts, automobile debts, and home mortgage
debt. Third, if you have children, you have future college costs that aren't
necessarily part of your current income needs. The income replacement approach
can adjust for these expenses by adding them on to your human life value
figure.
Considering differences in income
replacement needs during different future periods
The amount of income needed for family support may differ over time.
The time after the insured's death can be divided into different periods:
• Readjustment period
• Dependency period
• Blackout period
• Retirement period
You may wish to make allowances for the varying family support needs
during these periods. Typically, this type of analysis falls under the family
needs approach, but it can also be useful with the income replacement approach.
What are these periods?
Briefly, the readjustment period refers to the first one to two
years following the insured's death. During this period, the family pays off
the insured's remaining obligations and deals with the transition to life
without the insured. The dependency period refers to the years in which the
family must still support any children who aren't ready to be on their own. The
blackout period occurs after all children have grown up but before the
surviving spouse retires. Finally, the retirement period involves the surviving
spouse's retirement years. These periods are also covered in the discussion on
the family needs approach.
How can you make allowances for
different income needs during these periods?
Many financial planners recommend a relatively simple way to account
for differing family income needs during the readjustment, dependency,
blackout, and retirement periods. You take the insured's current income and
estimate the percentage of that income that would be necessary during the
different periods. Differences in children's dependency needs and the
availability of income from the surviving spouse factor into the various
estimates you make.
Strengths
More accurate than the rules of thumb
By taking into account inflation, salary increases, and several
factors unique to your family's situation (including the breadwinner's
remaining work years, other available assets and sources of income, and some
major lump-sum expenses), the income replacement method provides a more
accurate estimate of life insurance needs than the rules of thumb.
Relatively easy to understand
conceptually
Although income replacement approach calculations involve a number
of steps, they are relatively easy to understand conceptually. The idea of
maintaining a stream of income is more straightforward than accounting for a
long list of expenses in the family needs approach.
Tradeoffs
Requires more involved calculations
than some other approaches
The income replacement approach calculations involve more steps than
the very straightforward rules of thumb or even the more involved estate
preservation and liquidity needs approach.
Fails to consider family financial
needs in depth
The income replacement approach generally makes the assumption that
it is sufficient to look primarily at current income (or that percentage of
income that currently goes toward family support) when anticipating the
family's future financial needs. It provides for some adjustments but fails to
examine the future expenses in depth. Thus, this approach is generally less
precise than the family needs approach.
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The information presented here is not specific to any individual's
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To the extent that this material concerns tax matters, it is not
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purpose of avoiding penalties that may be imposed by law. Each taxpayer should
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