Insurance: How Much Life Insurance Do I Really Need?
One of the first things we come across on our personal finance journey, along with savings and investments, is insurance. Moe specifically, we usually get approached by a well meaning Financial Advisor or Insurance Agent very early on (perhaps when we are not even in the workforce yet!) and will be told about how Life Insurance helps to protect our loved ones in the event of our untimely demise. Along the way, we are usually also told that the appropriate amount of life insurance coverage to get is in the order of $500,000 or more, or maybe 10X our annual incomes! Which will no doubt seem a huge amount when we are barely in the workforce yet! While there is little question that life insurance is important, what we do need to know is, how much life insurance coverage do I really need?
How Much Life Insurance Do I Really Need to Protect My Loved Ones?
To work this out, there are two main approaches:
- By expenditure – how much do we need to cover the future expenses of my dependents and loved ones after I pass on?
- By future value – how much will I have earned and saved for my dependents and loved ones if not for my early demise?
We’ll talk a closer look at each of these approaches in the following.
How Much Life Insurance Coverage Do I Really Need? The expenditure approach to insurance
The first step to understanding why we need life insurance coverage and how much of it we need is to recognise that life insurance is a form of a financial hedge. If we have a risk, and we stand to lose something of value when that risk happens, we can insure against this risk, or hedge against it. Much like locking in the price of a home, or of foodstuff in advance of actually needing it, just to protect ourselves against a future loss when prices change. But similarly, there is a fine line between insuring ourselves against a possible loss, and speculating on the risk occurring in the future. For example, insuring ourselves for a sum of money in excess of what we stand to lose is just another form of speculation!
Now, the rule of thumb we usually hear, that we should insure ourselves for 10X our annual income is not exactly pulled out from thin air. It is in fact a figure from the Life Insurance Association Singapore back in 2017:
Protection Gap in Singapore 2017
From the table above, we see that the recommended amount of life insurance coverage is actually 9X the annual income of a person. And this has to be offset by the amount of savings and investment he/she already has. Which means that the typical advice to keep the same amount of life insurance coverage from the age of 25 to 65 (the retirement age) is not quite correct, as this assumes that the same person has, and will have, zero savings! We’ll come back to investigate this point in a while.
The second observation of this table is that it assumes that the average person insured has an annual income of $81,663, or $6,805 per month. This is actually higher than the median full time employed Singapore resident surveyed by the Ministry of Manpower in 2021 ($4,000). Since our expenditures generally follow our income quite closely, and in the long run, cannot exceed our income, this also means that the protection needs of $738,783 estimate by the Life Insurance Association is on the high side. Nevertheless, let’s just go with the assumptions made by the Life Insurance Association for the time being.
But what goes into the protection needs amount of $738,783, or 9X the annual income? The Life Insurance Association report also have the follow breakdown:
Life Insurance Protection Needs By Category
What is evident in the breakdown above, is that most of the protection needs are due to the future expenditure of a family unit. E.g. unpaid services (i.e. housework), housing loans, children’s needs, and household expenses. For someone new to the workforce, the protection needs are far lower, at some 7% of the total needs. After all, you are only liable for funeral expenses, personal loans, and the elderly needs of parents. In other words, instead of 9X annual income, a person who does not have dependents only needs insurance coverage based on expenditure needs of perhaps less than 1X annual income!
Hence, if you have no dependents, your life insurance needs are negligible. There is usually no need to insure in advance of setting up a family either, because the pricing of life insurance in Singapore is such that it actually gets cheaper relative to the risk of death as you get a little older, say in your 30’s, as we show in Term Life Insurance (2): How much does it cost to insure my life?
Often, we are told that it is cheaper in absolute terms to get insured when younger. But if we pay a lower premium, but for more years, and starting earlier, we will inevitably end up paying more overall than if we insured ourselves a bit later! Even if that means paying a higher premium, but for fear years, and starting later. That is the power of discounting for you, the close but often ignored twin sibling of compound interest!
Do I need the same amount of insurance throughout my life?
Assuming the Life Insurance Association report is accurate, the question is how do we actually implement it in practice. After all, the median monthly income is $4,000, and not $6,805 as assumed in the report. Also, we may earn less than that at the start of our career and more at the end of our career. And we will have savings and investments growing over time, and which can offset the amount of insurance needed. So, a static recommendation of having $738,783 of life insurance coverage, or 9X our annual income is really not very useful! What we can see is that the amount of life insurance coverage we need will vary over time. But how will it vary? Or, how much life insurance do I really need at each point in life?
To try to answer this, let’s use a model of income and savings we use d earlier in Are We Saving Too Much For Retirement? Basically, we assume:
- Our hero or heroine gets a job straight out of school at age 25, initially earning $2,500 a month
- The he/she gets a raise of 4% every year, and a promotion of 10% every 5 years, until he/she hits a maximum monthly pay of $15,000 a month after 35 years on the job (at age 60)
- A salary of $15,000 a month may seem high (and unrealistic?) at first, but if you only get it in 35 years time, it is worth less than $7,500 a month when you first started! So this is a pretty realistic scenario
- He/She will also reach the median monthly salary of $6,805 after about 20 years on the job (at age 45)
This is what the progression in monthly income looks like over time:
Assumed Monthly Income over Time with Median of $6,805
Along the way, from starting work at age 25 to retirement age 65, our hero or heroine can save according to either 2 methods:
- Plan 1: Start by saving 20% of monthly income, increasing by 10% every 10 years, until the savings rate reaches 50% at age 55 onwards
- Plan 2: Starting by saving nothing for 10 years, then saving 25% of monthly income at age 35 onwards, increasing by 10% every 5-10 years, until the savings rate reaches 55% at age 55 onwards
- Investing the savings at an annual return of 5%
Here’s what the annual spending and savings look like under each plan:
Savings Plan 1: Start saving immediately
Savings Plan 2: Start saving only after 10 years
Curiously enough, starting saving later does not have too great an impact on the total amount saved at the end of the day. While we tend to believe that it is better to start saving and investing as easy as possible, the fact is that most of our savings actually come from the later period in our lives, when our incomes increase! And spending more (when earning less) earlier in our lives can bring us more joy, as we can get to enjoy the flitting period of youth more!
Comparing saving early (from age 25) and saving later (from age 35 onwards)
Putting all these pieces together, i.e.:
- The income and savings models above
- An initial period of around 5 years without dependents where insurance coverage can be lower
- The recommended life insurance coverage of $738,783 to cover for future expenses of dependents and loved ones
What we see is that the required amount of life insurance coverage peaks in the early 30s (when setting up a family), and then falls continuously thereafter. And there is virtually no need for coverage anymore by the age of 50! This is because anyone with the discipline to insure, save and invest will likely have enough savings put aside by that age to provide for the future expenses of the dependents and lover ones!
Life Insurance Coverage Required By Age (Expenditure Approach)
If we are concerned with the future expenses of our dependents and loved ones only, we will not need life insurance coverage past the age of 50, as our savings and investments will be enough to cover these future expenses
So, what we learn is this:
- There is no need for life insurance coverage past the age of 50, as our savings and investments will be enough to cover the future expenses of our dependents and loved ones, if this is our main concern only
- Also, because the required amount of life insurance coverage falls continuously over time, it is better to either purchase decreasing term life insurance, or to purchase life insurance in tranches, say of $50,000 or $100,000, which can progressively mature or be lapsed over time, reducing the total coverage until it reaches zero at age 50
As we need less and less life insurance coverage over time, and because there is virtually no need for coverage after the age of 50, which is when the risk of death ticks up, the cost of getting insured for even a large amount like $738,783 or even $1 million is that much more affordable!
What about if I care about leaving my dependents and loved ones a pile of cash? The future value approach to insurance
But this is not the only way to think about insurance. For example, we might care about leaving our loved ones as much as we can. If we pass away early, we might not be able to save enough to leave them much, and this feels like shortchanging the people we love. So it is also possible to insure our future earnings and savings against the risk of death!
When thinking about personal finance in general, and life insurance in particular using the future value approach, a common mistake is to think of future value and net worth in terms of gross income, i.e. like the future interest payments from a bond. But unlike a bond, which pays us even if we do nothing, earning an income and saving it requires us to live and have expenses. Hence, the correct way to think about future net worth, or the value of future income is to only consider the net income, i.e. savings after spending. This is what we do here. A further refinement is to consider the riskiness of future income, so a day trade with volatile income will value his/her future earnings at a lower amount than a civil servant, for example, as discussed here.
So, going back to the model of income and savings used earlier, at every age, we can present value the sum of expected future savings (using a discount rate of 2.5%). And we can also do this under the two different savings plans as well. The present value of the remaining future savings will then be equal to the amount of life insurance cover we need at that age, to provide your loved ones with the amount of money that you’d have given them, should you have lived. We show this below:
Life Insurance Coverage Required By Age (Future Value Approach)
Like the expenditure approach to life insurance coverage, the amount of life insurance we need under the future value approach also peaks, and then falls over time. But in this case, the amount of life insurance coverage required peaks at the middle of the working career (around age 45), before falling off to zero at the end of the working career (age 65). The later peak occurs here because the larger savings are made towards the end of the working career, so as they get nearer in time (i.e. in middle age), the discounted value goes up. And at age 65, upon retirement, you’d have no future value of savings to insure, which is why the required coverage falls to zero at this point too.
Of course this depends on the level of wealth too. For example, if you already have $10 million in assets, insuring yourself for another $1 million does not make much of a difference!
However, the broad recommendations under the future value approach to life insurance coverage are similar to those under the expenditure approach. Our needs for coverage rises at first with age, and then falls over time. Which argues again for either purchase of decreasing term life insurance, or buying life insurance in tranches, which can mature or be lapsed as they are no longer needed.
How much insurance do I really need? Conclusions
The typical Financial Advisor or Insurance Agent you’ll meet early in your working career will usually advise you to get life insurance coverage of 10X your annual income, all the way until retirement age at 60 or 65. And as we see upon closer examination, this is very much a convenient and profitable shorthand for them, as actually advising on the life insurance profile you need will take much more work!
The thing is that, our savings will grow over time. So if you are only concerned with providing for your dependents and loved ones in the event of your untimely demise, don’t forget that you’ll be passing your retirement savings to them too, and this helps to offset the amount of insurance you need. Even if you are concerned with passing on as much as you can to your loved ones, the message is still the same. Our insurance needs decline over time, and fall to zero between the ages of 50 to 65.
Which means we need to take a closer look at either purchasing decreasing term insurance, or buying life insurance in tranches. This will better match our life insurance coverage requirements according to our stage of life and savings.
You can read some of our other blogposts on insurance here:
- Term Life Insurance (2): How much does it cost to insure my life?
- Should I Care about Careshield Life? Is it a rip-off?
- Should I bother switching from ElderShield to CareShield Life?
- The Merdeka Generation’s Guide to How to Make Sure Your Medisave Does Not Run Out
- Are Returns on Endowment Policies worth your time & investment?
- Greedy doctors, overpaid agents, or kiasu patients? What is wrong with Integrated Plans?
- Greedy doctors, overpaid agents, or kiasu patients? A few clarifications
- Is the CPF LIFE Escalating Plan the best plan?
- CPF LIFE: Some surprising changes for 2022
- Insurance: When to get insured, and when not to
- Insurance: Emergency Funds As Self-Insurance
- Insurance: How Much Should I Be Spending on Insurance?