Life insurance may be the most badly purchased financial product. Some people, unwilling to face the thought of death, never buy coverage at all. Others feel guilty about the prospect of leaving loved ones behind and buy too much. Even those who put their emotions aside tend to fall back on oft-repeated and oft-wrong rules of thumb, such as buying a policy worth five times your annual salary.
Choosing the right amount of life insurance is no easy matter. Even most insurance agents and financial planners rely on rules of thumb or unsophisticated worksheets -- or put the onus on clients to decide how much insurance to carry. Fortunately, understanding a few economic principles will go a long way toward helping you make a smart decision.
According to economists, your family's financial goal should be to enjoy the highest standard of living possible over a lifetime. That may mean borrowing when you're young and repaying the loans as you age and earn more. Given your total lifetime income, you don't want to suffer in youth and live high on the hog in old age, or vice versa.
That's where life insurance comes in. If you die, the death benefit to your survivors should be precisely large enough so they enjoy the same living standard as they did while you were alive. Life insurance protects your family if you die young. It goes hand in hand with investing for retirement, which protects you against the opposite risk: that you and your spouse will outlive your savings.
The focus on smoothing consumption over a lifetime leads to some counterintuitive conclusions. It indicates that young people are the most likely to be underinsured, that secondary earners and nonworking spouses are the most likely to be overinsured, and that most people should reduce the amount of life insurance they carry as they approach retirement. "When it comes to buying life insurance, economic man is making major mistakes," economists Jagadeesh Gokhale, a senior fellow at the Cato Institute, and Laurence Kotlikoff of Boston University wrote in a 2002 paper.
Gokhale and Kotlikoff have done more than chastise people for bad decisions. They have distilled their research into a sophisticated program that digests scads of personal data and spits out a multiyear financial plan with annual targets for spending, saving, and insurance coverage. The calculations are so complicated that even a state-of-the-art PC takes 15 seconds to produce a result. The $149 program, ESPlanner, is sold by a company that Kotlikoff helped found, Economic Security Planning Inc. in Lexington, Mass. (esplanner.com).
Even if you don't buy the program, you can learn a lot by looking at life insurance through an economic lens. Start with what economic theory says about the young. Many people who are starting families buy a little life insurance coverage, then add more as their incomes increase and they can afford more protection. That's the opposite of what you should do. You want the most coverage when you have just started a family, because the insurance has to cover decades of future earnings that will be lost if you die. As you get older, you can afford to decrease coverage because you have fewer years of earnings to make up for, your spouse has more assets to live off of and fewer years of life remaining, and your children are closer to being on their own.
Those factors have big implications for what kind of insurance is appropriate. Insurance agents often advocate cash-value policies because they double as investment vehicles. With simple term insurance, they argue, you're left with nothing to show for your years of premium payments. That's true. But the only way most young people can afford to buy as much life insurance as economic theory says they need is to opt for term policies that pay a death benefit and nothing more. A 25-year-old can buy a $2 million, 30-year policy from a reputable insurer for about $1,600 a year. That same premium would buy a death benefit of only a quarter as much -- $500,000 -- if it were put into a variable universal life policy that has an investment feature. Younger people should place protecting future income ahead of piling up savings, but many succumb to agents' sales pitches for cash-value policies. According to the latest available numbers from the American Council of Life Insurers, whole, universal, and variable life policies account for 84% of premiums, vs. only 16% for term policies.
Thinking like an economist can sometimes lead you to buy less insurance, not more. In ESPlanner's software, secondary earners often require little or no life insurance, even taking into account that the secondary earner (most often the wife) often provides essential services that must be replaced, such as child care. Why? Mainly because child care is a relatively short-term issue. When the secondary earner is gone, the need to support that person until, say, age 95 is gone, too.
If you want to follow economists' advice and reduce your coverage as you approach retirement, inflation will take care of part of your problem by eroding the real value of your death benefit. A $2 million policy will be worth just $1.1 million in today's dollars in 20 years, assuming 3% inflation. Also, some insurers offer policies that have level premiums but declining coverage over time.
A good way to shrink your coverage over time is to buy policies of different durations and layer them. If you want to start with $1.5 million in coverage and then have it decline, buy three $500,000 policies. Make the first expire after 10 years, the second after 20, and the third after 30 years. That will give you a smoothly declining amount of coverage as you glide toward retirement.
No one enjoys buying life insurance. But if you think like an economist, you can come away feeling like you've at least correctly calculated the odds.
By Peter Coy