Inflation Eats Life Insurance
Have you considered what inflation does to your life insurance?
Everybody understands inflation. Inflation eats away the buying power of your money. Simple enough, right?
I’ve posted in the past about the need to have adequate term life insurance. I also post quite a bit about inflation. The two discussions intersect in an important way.
When calculating how much life insurance you need, do not forget to factor in inflation. When my wife and I bought our policies after our daughter was born, I didn’t consciously do this, but I did without really thinking about it.
Figuring out how much life insurance you need
The basics of figuring out how much life insurance you need are pretty simple. I’m not saying this is the way to do it, but my ‘formula’ is to total all your liabilities (mortgage, car note, student loans); add in the estimated cost of college for your kid(s) if you plan on paying all or part of that; multiply your income by the number of years it’s needed (typically until your kids are out of the house); multiply it all by a fudge factor and you’re done.
It’s that last part where you figure in inflation implicitly. I added all our items and multiplied by 1.25. Why 1.25? I don’t know - I just figured inflation would increase the cost of living and it was a nice round number. Pretty scientific, huh? Remember, I’m not claiming this is the right way to do it, just that this is how I did it.
The point isn’t that any specific fudge factor is right. Just that you need to consider that inflation will slowly destroy the purchasing power of your insurance benefit.
If you didn’t do this when you initially figured out how much insurance to buy, you can still recover. It’s simple to rewrite a policy to increase the amount of insurance. It might cost you in the form of a higher rate, since you’re older now. However, it might not, since life insurance is one of those few things getting cheaper over time. If you’re concerned about cost, check out this post on what to do if additional insurance is too costly.
inflation insurance
June 13th, 2007 at 12:41 pm
Well there’s also the idea that you need less insurance protection as your policy ages which cancels out the inflation aspect. You have a newborn so you need the insurance lumpsum payout to last 20 years until your kid is graduated from college. 10 years later, costs have gone up but the lumpsum only needs to last 10 years.
June 13th, 2007 at 2:40 pm
I too am about to have a newborn, and we simply calculated term life insurance as roughly 10x our income. We figured if we could get close to 10% interest on the insurance then the “nest egg” is never tapped and just 10x our income invested wisely could be enough to replace our income until our child is in college.
We’re young and don’t have a huge savings nest egg established yet which could have lowered that multiplier from 10 downward based on our savings. And you could also bump the multiplier up if you have debt or absolutely no savings to account for inflation. But for most households somewhere in the 7-12x income does the trick.
June 13th, 2007 at 9:36 pm
[…] Personal Finance considers the impact inflation has on life insurance. I never thought about that either as I hope nobody will need to collect the […]
June 30th, 2008 at 11:30 pm
Fuggedaboutit :).
For most of us we’re buying insurance to replace our income should we die. So let’s say we want to ensure our dependents have an income for the next 20 years if we die tomorrow.
In 5 years time, yes the present value of the death benefit will have decreased. But now you only need to replace your income should you die for 15 years - you’re 5 years closer to having the kids out of the house, having the mortgage paid off, etc.
In other words, yes, inflation will eat at your death benefit. But in many cases we make the assumption that our need for life insurance decreases over time. Without running the numbers, I suspect that our need probably decreases faster than inflation chips away at the death benefit.