A common question in this business is: how much life insurance should I buy?

When an insurance agent throws out figures like “$1,000,000″, it’s easy to ‘freak out.” But, should you? Think about it for a moment.

The semi-famous (in certain circles) research conducted by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz of Trinity University shows that you should really only count on a 4-5% withdrawal rate on a lump sum of money over a long period of time.

For example: Start with $1,000,000. Flip a coin. Tails represents a 10% loss (-10%). Heads represents a 30% gain (+30%). If you are rolling alternating heads and tails, you could withdraw $81,700 (8.17% of the initial amount) over the next 30 years before all of your money runs out.

But, if you roll 15 straight tails before rolling 15 straight heads, you can only take $18,600 per year. If you reverse the process and roll 15 heads and then 15 tails, you can withdraw $248,600 per year. According to Cooley, Hubbard, and Walz, the success rate of various withdrawal strategies across many historical periods can vary widely. They analyzed these withdrawal strategies and came to a pretty shocking conclusion: only a 4-5% withdraw rate (of the original portfolio balance) is reasonably sustainable over a long period of time.

So, if you make $50,000 and if you want to make sure that, if you die prematurely, your spouse can keep your income coming in (and adjust for the retirement savings that they can no longer contribute), then $1,000,000 is not “overdoing it” when it comes to buying that insurance policy. You will need $1 million to earn $50,000 a year in interest at 5% and not run out of money or dig into the principal.

Many people have heard “rules of thumb” of 5 times income…10 times income…30 times income. What you are really supposed to be doing is figuring out how much of your net income (after taxes) you want your spouse to keep if you die, and then divide that number by 4% or 5% (whatever you feel more comfortable with).

When it comes time to figure out how to pay for the premiums…that’s when you need a financial adviser.

You might also like

1. Will You Outlive Your Investments?
2. Life Insurance Basics – It’s Not As Bad As You Think
3. Life Insurance: Myths & Facts

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This entry was posted on January 2nd, 2012 by David C Lewis, RFC. Edits may have been made to keep this entry current. · No Comments · Insurance & Savings