The Right Way to Understand the Cost of Term Life Insurance Is “Additional Months of Work Required”
Key Takeaways About Term Life Insurance:
Employer-provided life insurance usually provides insufficient financial protection for working-age families
Term life insurance provides an affordable solution to protect families in case one or both of the spouses unexpectedly passes away.
While paying for term life insurance will be an additional expense for families, the cost of this insurance for healthy household members can usually be paid for by working an additional 6-18 months at the end of their careers.
When advising working-age clients, I almost invariably recommend that clients buy term life insurance. But many clients have questions on how to think about whether term life insurance is "worth it."
The answer is almost always: yes, term life insurance is worth the cost. But you have to think about cost differently. This article explains why.
Employer-Provided Life Insurance Is Rarely Enough
Most of my working-age clients receive some sort of life insurance benefit through work. But many incorrectly think that their group life coverage through work will enable the surviving spouse and children to maintain something close to their current standard of living.
This is almost always false. The loss of a spouse's income can have a devastating effect on the survivors. This is especially true if there is one primary breadwinner who brings in the lion's share of the household's income.
Life insurance provided through work is typically limited to 1-3x the employee's earnings. And when you run the numbers on whether a family can maintain its standard of living when the higher earning spouse passes away, the results invariably show that the survivors incur huge financial harm from the death of the higher-earning spouse, even with the life insurance provided through work.
Illustrative Case Study of the Benefit of Term Life Insurance
To demonstrate how devastating the loss of a working-age spouse can be, I created a basic illustrative scenario in eMoney Advisor, a financial planning software application that I use with clients.
I used the following assumptions for the hypothetical Jones Family:
Alan and Betty Jones are both 43 years old and they have two twin children aged 12.
Alan is a private school guidance counselor who earns $80,000 per year; Betty is a human resources consultant who earns $140,000 per year. Their salaries are projected to grow with inflation.
They currently have $625,000 of investments across several brokerage, retirement and 529 accounts.
They own a house and have a mortgage with a $400,000 balance outstanding.
I made some assumptions around household expenses, child raising costs and college education costs that are typical for families like the Joneses.
I also assumed that the Joneses would earn a little over 6% on their investments every year.
The Joneses would like to retire at age 65 and start taking social security at normal retirement age.
When I run the long-term retirement analysis in eMoney, the Joneses look like they are in a good position to achieve their retirement goal. At age 65, they will have total investments of about $2.75 million at age 64. That provides plenty of money for the Joneses to live a comfortable retirement and to provide a significant inheritance to their two children. The chart below shows how the Joneses' investment accounts grow over time.
Chart 1 - Jones Investment Account Balances - Both Spouses Work to Age 65
Source: Quiet Wealth. Analysis derived from eMoney Advisor.
Now let's run a scenario where Betty, the higher earning spouse, dies in 2024. Betty has life insurance through work that pays 2x her income, or $280,000, to Alan. But is that enough? The chart below shows the results:
Chart 2 - Jones Investment Account Balances - Betty Dies at Age 44 - $280,000 Life Insurance Benefit from Work
Source: Quiet Wealth. Analysis derived from eMoney Advisor.
The additional $280,000 temporarily helps Alan and the kids, but the costs of maintaining the house and raising the children eventually take a toll on the household finances, especially when the kids go to college. In practice, Alan would probably have to cut back significantly on household expenses and probably downsize to a smaller home to pay for the kids' expenses and enable Alan to save sufficiently for his retirement.
I personally know a couple of households that went through this exact scenario where one of the spouses died when the couple had school-aged children, and the decedent had insufficient life insurance. It is not a good situation.
The Solution: Term Life Insurance
Fortunately, there is a solution to this problem, which is for Alan and Betty to both buy term life insurance. One of the great things about the eMoney Advisor is that the platform can easily show you how much life insurance is necessary.
Let's assume that both Alan and Betty buy $1,000,000 20-year term life policies.
Now let's say that Betty dies at age 44 - here's what the chart looks like:
Chart 3 - Jones Investment Account Balances - Betty Dies at Age 44 - $280,000 Life Insurance Benefit from Work & $1,000,000 Term Life Insurance Death Benefit
Source: Quiet Wealth. Analysis derived from eMoney Advisor.
As the chart above shows, the additional $1,000,000 of life insurance enables Alan to raise the children, pay off the mortgage of the house and to retire with about $2.8 million in savings.
In retirement, Alan's income is not as strong as before, because Alan doesn't have Betty's social security income, and this results in a slow decline in Alan's investment accounts through retirement. This problem could be solved by Betty buying an additional $250,000 of life insurance for a few hundred dollars more per year, assuming Betty is relatively healthy.
But is the cost of term life insurance worth it?
So how much would it cost for Alan and Betty to both buy $1,000,000 of life insurance?
That depends on their health and other factors. But if Alan and Betty are non-smokers and reasonably healthy, Alan would pay around $1,200 per year and Betty would pay around $1,000 per year.
It's at this point in the financial planning process when many of my clients say the following:
"Wow - $2,200 per year seems like a decent amount of money. Is it worth paying this cost? And if neither of us dies, that's money down the drain."
And I kind of agree: $2,200 per year is a lot of money! But we already know how much a $1,000,000 death benefit would help the survivors.
And I think that a better way to think about the cost of life insurance is by answering the following question:
"How much longer do the spouses have to work to end up with the same amount of money at the beginning of retirement?"
In effect, the $2,200 per year going to life insurance results in a reduction of retirement savings for Alan and Betty. And not only is the couple out of pocket $2,200 per year, but they're also losing all the investment gains on that money that they would have made over their remaining 22 years of working.
So I ran an analysis to see how much money the couple would have at age 64 both with and without paying for life insurance.
Investment balance at age 64 without life insurance: $2,750,587
Investment balance at age 64 with life insurance: $2,615,041
Difference: $135,546
In other words, paying for 20 years of life insurance cost the Joneses $135,546 in premiums and lost investment gains.
Again, this seems like a lot of money, but fortunately there is an easy solution…
Just Work a Few Months Longer Prior to Retiring To Get Back to the Same Place!
At age 64, Alan and Betty will be earning approximately $377,153 combined because of inflation (I assumed a 2.6% inflation rate).
So how much longer would Alan and Betty need to work in order to make up the $135,546? If you assume that Betty and Alan have an average income tax rate of 20%, they would need to earn an additional $169,433. That's about 4 1/2 months of work.
This is when I ask the couple: Are you willing to work an additional 4-6 months before retiring to pay for the cost of term life insurance during your working years?
And the answer is always: yes. An additional few months of work seems like a trivial cost to protect the family if one of the spouses passes away.
In practice, the number of months of additional work years required to pay for life insurance is generally between 6-18 months. The length of this payback time depends on the current state of the household's retirement savings, the percentage impact of the premiums on the retirement savings rate, and the health of the insured parties. But for middle/upper-income couples with decent existing retirement savings and decent health, I rarely see a situation where the amount of additional working time is greater than 18 months.
Consequently, for most healthy couples, the decision to buy term life insurance is usually a no-brainer because the cost in time is relatively low.
Who doesn't need term life insurance?
There are some groups of people who don't need term life insurance. These include:
Retirees who don't have a mortgage and have sufficient savings to enable the survivor to live comfortably on that savings and the survivor's social security income.
Single persons who have no minor children, no parents or any other people who may depend on them either now or in the future.
Spouses who do not currently work and do not intend to ever work again in the future.
Spouses who earn much, much less than the high-earning spouse.
Very, very wealthy people. (However, these people may own life insurance for tax planning purposes)
And that's about it… almost every other household probably needs term life insurance.
Should I buy additional life insurance through work instead of buying personally-owned term life insurance?
Many employers offer the option to employees to buy additional life insurance through work above and beyond the base life insurance. Is this the right thing to do?
Short answer: no.
Here's why:
I have found that cost of optional supplemental life insurance through work is only marginally less expensive than individually-owned term life insurance.
You usually can't immediately buy the level of life insurance that you need through work. Very often, employers and the group-plan insurance companies require you to buy into additional life insurance over many years.
Most importantly, your life insurance through work is tied to your employment, and this is a very bad thing. Here's an example of where Group Life Insurance leads to a bad outcome:
Employee finds out that he has cancer and has 18 months to live.
But Employee bought $1,000,000 of life insurance through work.
However, to receive the death benefit, Employee has to keep working at his job, even though Employee would prefer quitting work to spend remaining time enjoying life.
In some cases (but not always), the employee may be able to convert the existing policy into an individually-owned permanent life policy, but this can be very expensive.
In other words, group life insurance can be a real pain to deal with at exactly the point you need it. That is why to skip it and instead buy individually-owned life insurance.
Conclusion: If You Think That You May Need Term Life Insurance, You Probably Do
The vast majority of my working-age clients who come to me are significantly under-insured for life insurance. I can't emphasize how important it is to have the proper level of term life insurance as part of an overall financial plan.
Is term life insurance costly? Sort of. It probably will cost anywhere from 1-4% of your income per year depending on your circumstances. That's not nothing. But the solution to pay for the cost of life insurance is simply to work a few months longer before retiring.