Life Insurance Needs: Capital
Liquidation Approach
What is the capital liquidation
approach?
The capital liquidation approach is one of
two methods of calculating your family's life insurance needs under the family
needs approach. It is not an independent approach. Rather, it is one of two
ways to determine the lump sum of insurance proceeds the surviving spouse needs
to receive and invest to provide for ongoing family income needs. Under this
approach, you estimate the necessary lump sum assuming that you will be
liquidating all the proceeds over the surviving spouse's remaining life
expectancy. The idea is that the proceeds, or capital, will be used up either
at or slightly after the end of the surviving spouse's life expectancy. In
other words, your family's life insurance proceeds should last just through the
four ongoing income periods: readjustment, dependency, blackout, and
retirement. This way, you reduce the amount of life insurance you need to
purchase while covering for your family's needs under the most likely scenario:
the surviving spouse not living significantly beyond his or her life
expectancy.
Under the alternative capital retention
approach, you purchase more life insurance to retain all of the principal for
supporting the family indefinitely into the future.
As a result, you are better
positioned for either of the following situations:
1) Your
surviving spouse outliving predicted life expectancy
2) Your
wanting the heirs to inherit some of the proceeds after the surviving spouse
dies
You have to pay more up front in premiums,
however. For example, you estimate an insurance need of $800,000 for the 30
years of your surviving spouse's life expectancy using the family needs
approach. If you use the capital liquidation approach, you can settle for
somewhat smaller insurance proceeds because you won't depend entirely on the
investment returns for the $800,000 need. Some or all of the proceeds
themselves--the capital--will supplement investment returns to provide the
$800,000 needed by your family. If, on the other hand, you use the capital
retention approach, you will want proceeds that, if invested, will yield $800,000
during this period entirely from the investment returns.
Why choose the capital
liquidation approach?
You should focus on capital liquidation when
using the family needs approach if you wish to spend less on life insurance to
cover your family's ongoing income needs. At the same time, you should be
comfortable with using up your family's available life insurance proceeds over
the course of the surviving spouse's remaining life expectancy. Of the two
approaches, capital liquidation arguably is the riskier approach. You are
gambling that the surviving spouse won't substantially outlive his or her life
expectancy. If the spouse does, the family won't have any insurance proceeds
left to liquidate in order to provide for the spouse's continuing income needs.
Strengths
Less spent on
life insurance
If you focus on capital liquidation when
using the family needs approach, you can spend less on life insurance than if
you were concerned with preserving some or all of the insurance proceeds into
the indefinite future.
Tradeoffs
Risk that the
surviving spouse will outlive the insurance proceeds
Under this approach, the insurance proceeds
will be liquidated over the surviving spouse's remaining life expectancy or
perhaps slightly longer. If the surviving spouse significantly outlives his or
her life expectancy, your family may have no proceeds left to generate needed
income. (Interestingly, in the past several years, actuarial experts
(actuaries) have projected much higher life expectancies for most Americans,
barring war, epidemic, or natural disaster. Most insurance companies have yet
to update their actuarial tables to reflect the longer average life span. If
these projections hold true, then the capital liquidation approach will be much
more risky.)
May not be
able to pass the capital to heirs
If the surviving spouse lives at least as
long as his or her life expectancy, the heirs won't be able to inherit any of
the capital represented by the insurance proceeds, because the proceeds will
have been exhausted. If the surviving spouse dies before the end of his or her
life expectancy, a portion of the proceeds may have been used up and may be no
longer available to the heirs.
How to use the capital
liquidation approach
Generally speaking, the family needs approach
requires you to make the following calculations in order to estimate life
insurance needs:
Immediate needs at death
Ongoing family income needs
Expected other income sources
The following equation yields an estimate of
the insurance you need:
Immediate needs at death + Ongoing family
income needs -Expected other income sources = Family needs
Your choice of the capital liquidation
approach versus the capital retention approach affects your figures for the
insurance amount necessary to cover the ongoing family income needs. If you
choose capital liquidation as opposed to capital retention, you won't require
as much insurance proceeds to invest in order to cover the ongoing family
income needs.
CornerStone Financial
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do not hesitate to contact us if you have questions.
Contact:
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President/CEO
CornerStone
Financial
(615) 427-8780
IMPORTANT DISCLOSURES
The
information presented here is not specific to any individual's personal
circumstances.
To the extent
that this material concerns tax matters, it is not intended or written to be
used, and cannot be used, by a taxpayer for the purpose of avoiding penalties
that may be imposed by law. Each taxpayer should seek independent advice from a
tax professional based on his or her individual circumstances.
