Most people know that SGLI is the cheapest life insurance available. Full coverage under SGLI costs $28.00/month for $400,000 in coverage (or about 7 cents/month for every $1,000 in coverage). Unfortunately, this creates two problems:
- SGLI’s pricing leads people into thinking that all life insurance should be this cheap.
- The $400,000 ceiling leads many people into thinking that all they need is $400,000 in life insurance, regardless of what’s going on in their life.
Both of these assumptions leave many families in a very precarious financial situation. This article won’t address why commercial life insurance (even term insurance) isn’t as inexpensive as SGLI. It also won’t give you a ‘one size fits all answer on how much life insurance you need.’ There is no ‘best’ answer here. The best answer is one that helps you sleep at night.
This two-part article will outline three ways many fee-only financial planners help families figure out their life insurance needs so they can obtain coverage that’s appropriate for them. Part one focuses on determining the life insurance needs to cover the primary breadwinner’s lost income. There are families where the servicemember is not necessarily the primary breadwinner. However, for purposes of this article, we will assume that the primary breadwinner is the servicemember. Part two will focus on insuring the spouse with Familymember SGLI.
Overview – Your Life Insurance Needs will Change with Time
Before we get too far, it’s important to note that life insurance needs change over time. For example, I was 17 when I joined the Navy. Although I sent money home to my mother, there was no real need. I took SGLI because it was available. If I had died, I’m sure that my mother would have appreciated the payout. After I got married, my wife was still working. She probably would have appreciated the payout as well, but I suspect that in our first few years, there wasn’t a real NEED for life insurance.
It wasn’t until our life became complex that the need for life insurance arose. First, we bought a house. Then we had a child. Then three children (yep, our twins helped us skip from 1 to 3). Promotions & pay raises over the course of a career. You get it…most military families follow this same pattern.
At each step, our life insurance needs changed…even if we didn’t change our life insurance coverage. For each child, there’s an expectation that there will be SOME additional money to help pay for the costs of raising that child. For each promotion or pay raise, there’s an expectation to PROTECT the current & future cash flows.
While it’s hard to quantify, it’s easy to understand that each life event has an impact on life insurance needs. It goes both ways, as well. As children leave the house and start their own lives, life insurance requirements go down. As you accumulate more wealth, your life insurance needs may go down (although your umbrella liability coverages should go up accordingly to protect your wealth).
When you retire, your life insurance needs go down. Some might argue that when you reach financial independence and stop working, your insurance needs go down to zero, since you’re no longer protecting cash flows from future income. That’s a topic for a debate, but not in this article.
Calculating Life Insurance Needs
There are many ways to calculate life insurance needs. Here are three ways financial planners do so:
Method 1: Ten times income:
This is a simple rule of thumb that has existed in the life insurance industry for years. As with many simple rules, it’s easy to be misled by ‘setting it & forgetting it.’ Three problems are:
- Many people purchase a life insurance policy at 10X income when they’re earning lower incomes, but forget to make adjustments when they start to make more money.
- This rule doesn’t account for debt or immediate expenditures. Mortgages, car loans, etc. are not factored into this formula. Neither are funeral or burial costs, which can easily reach into the 5 figure range. Neither are college costs for families with children.
- For most people, this isn’t enough to achieve any sort of financial independence. This contrasts with the retirement rule of thumb. If 4% is generally considered a safe withdrawal rate for retirement planning purposes, then the retirement rule of thumb is that 25 times living expenses should afford a fairly decent retirement. Unless you’re living WAY below your means, 10 times income does not translate into 25 times living expenses. Following this rule would mean that the surviving spouse would have to:
- A) Make serious permanent changes to their life
- B) Use these proceeds to set up the next chapter of their life
- C) A combination of both A & B
Method 2: Ten times income plus debt (and/or college expenses):
This is a variation on the previous rule that accounts for debt. This can be incurred debt, such as mortgage or car debt. It can also be implied future debt, such as college expenses for your children. This still doesn’t guarantee that the surviving spouse can retire on these life insurance proceeds. However, paying off debt reduces living expenses. In turn, this can bring that ratio closer to the 25 times living expenses goal.
Method 3: The DIME formula:
The DIME formula incorporates everything mentioned above into a simple acronym:
- Debt & final expenses (not including mortgage).
This includes outstanding debt, such as car loans, credit cards, etc. It also includes funeral & burial expenses.
- Income: The difference here is that instead of relying upon a 10X income rule, you determine the number of years your family would be relying upon. Let’s imagine a family with younger children. They might want to replace that income until their youngest graduates from high school. Perhaps it’s college. Whatever the case may be, they choose, not the formula.
- Mortgage: Mortgage is included, although the formula might not make as much sense if mortgage wasn’t broken out separately. For those with rental properties, it may make sense to include some (or all) of the rental property mortgages as well.
- Education: Cost for each child’s education.
The point of the DIME formula is to provoke thoughtful consideration for each need. Once that’s done, it’s relatively easier to add up each of those needs to figure out how much life insurance you need.
In each case, you can decide whether to decrease insurance needs by the amount of savings & investments you already have. You can also decide whether this includes retirement assets, as the 10% early withdrawal penalty does not apply in the case of death. However, you do pay ordinary income tax rates on any withdrawals from a traditional retirement account.
Another important consideration is that none of these scenarios account for the preferred tax treatment for allowances. Since allowances are not taxed, it takes a larger amount of after-tax income to replace them. Using the traditional life insurance replacement formulas to replace what you see in your LES, you might be shortchanging yourself if you’re looking to use traditional financial planning principles in calculating your insurance needs. The higher your income bracket, the larger this difference can be. Whether you choose to do so in your insurance planning calculations is up to you.
The calculations in this formula are done without respect to the tax treatment of allowances. However, this is purely for the convenience of writing my article. It may be worth looking at your tax situation to determine whether you should factor this into your own insurance planning.
This article also doesn’t look at incentive pays, special pays, or bonuses. All of these are dependent on the nature of a military career, and should be factored into insurance planning.
Life Insurance Case Study
Let’s imagine a young military couple, the Smiths, who are stationed in Norfolk. Petty Officer Smith is an E-5, with 8 years in. Like most military folks, Petty Officer Smith has full SGLI coverage. They’re pretty focused on staying in for 20 years. He’s even considering becoming an officer. They just bought a $250,000 house in Virginia Beach, which they put 10% down upon. They’ve managed to save $10K in an emergency fund and $50K in his TSP. Also, they have two young children, ages 5 & 2. They plan for their children to go to one of Virginia’s public colleges. They expect to save $100K for each child to go to college. For simplicity’s sake, he does not have any special pays, incentives, or bonuses. He expects that he will never be offered them, either.
Let’s evaluate their life insurance coverage under each of the three planning methodologies:
10X income: Given the above information, the Smiths make $5,028 per month from basic pay, Basic Allowance for Housing (BAH), and BAS (Basic Allowance for Subsistence). This amounts to $60,336, not including clothing replacement allowance. Multiply this by 10 gives us $603,360 in insurable need. In this case, finding $600,000 in coverage would be appropriate (albeit not a rounded number that most insurance companies use).
Some people might discount the insurable need by how much they’ve saved. However, this couple is young. It might make sense for them to leave that money alone, particularly since insurance coverage is relatively cheap.
However, you can discount this by the amount of SGLI they have, as well as the $100K death gratuity. Doing so would leave you with $100,000 in coverage needs.
The problem with this is two-fold:
- They’re relatively young. This does not account for the fact that he expects his compensation to grow over time, particularly if he becomes an officer.
- This doesn’t account for their mortgage, which is over $200K, or their children’s’ future college expenses, which could be over $100K each. Covering just these two items could wipe out the SGLI, leaving Mrs. Smith less than $250K to start over with.
10X income plus mortgage & college: Using this methodology, we come up with the $600K mentioned above, plus $225K for the mortgage and $100K for each child. This brings the insurance need to $1 million. Backing out SGLI leaves them with $500K in policy needs.
Obtaining a $500K policy in addition to the SGLI would allow Mrs. Smith to pay off her house, fund her children’s college with just under $500K to raise her children with. This still does not account for allowance increases, pay raises or promotions that may happen over the course of Petty Officer Smith’s career.
DIME formula: Let’s assume the Smiths would want to replace Petty Officer Smith’s E-5 pay until their youngest child graduates college. This is how that formula would look:
- Debt & expenses (not including mortgage): Looking at expenses, let’s factor in $10,000 for funeral and burial costs. Since the other formulas didn’t look at car debt, let’s factor in another $20,000 for each of their two cars. Total: $50,000
- Income: We’re now replacing Petty Officer Smith’s income for 19 years (we’ll assume the youngest graduates college on time): $1,150,000 (rounded up from $1,146,384)
- Mortgage: $225,000
- Education: $200,000
Using this formula, we arrive at $1,625,000 (or $1,125,000 after SGLI and the death gratuity). Most insurance companies would provide coverage at $1 million or $1.5 million, but not at $1,125,000. Coverage at $1.5 million would allow Mrs. Smith to fully fund college, pay funeral expenses, and pay off the cars & mortgage. It would also allow her to raise their children at their current salary level until they graduate college.
This formula still wouldn’t guarantee that Mrs. Smith will have enough money to never work again. However, this coverage does buy her a significant amount of time. She can use this time to adjust to the new life that lies ahead of her. The hope is that she will have made enough adjustments so that she is financially stable by the time her children go to college.
However, this still does not account for any potential future earnings that Petty Officer Smith may have had.
The Biggest Drawback
The biggest drawback to all of this is something that I haven’t mentioned yet: None of these plans factor the possibility of Petty Officer Smith’s future retirement income! Traditional life insurance planning has long foregone the possibility of pensions, simply because most people aren’t offered defined benefit pensions any more.
While the Blended Retirement System changes throw some complexity into this, it seems completely appropriate that life insurance planning should at least consider the possibility of the servicemember’s future eligibility for a pension. Remember, the Survivor Benefit Plan (SBP) only applies for:
- Servicemembers who are eligible for retirement
- Servicemembers who aren’t eligible for retirement, but is determined to have died in the line of duty
In other words, if the Smiths make it to 18 years, then Smith dies, Mrs. Smith has to rely upon the military to make a line of duty determination in order to receive SBP benefits. That’s a huge assumption which you might not want to rely upon in life insurance planning.
Remember, when planning for future earnings growth, you don’t have to exactly map out what the future holds. While your insurance coverage should have some reasonable basis, it doesn’t have to (and probably won’t be) exactly correct. But it should be in the ball park. And to be in the ball park, you should at least consider the potential for future earnings.
How to Account For Future Earnings Growth
There are many ways to account for future earnings growth in insurance planning. I’ll outlined two:
Make assumptions early & buy insurance based upon those assumptions.
Let’s imagine that Petty Officer Smith plans to become a limited duty officer (LDO). Based upon the career track of LDOs in his community, he can reasonably expect to become an officer, then retire as an O-5. At that point, he would retire with 25 years of service. I won’t detail the calculations here, but we can assume that his insurance needs could be higher due to his potentially higher future earnings & pension income. A benefit to securing insurance coverage now is being able to take advantage of lower insurance premiums. As people get older, insurance rates go up. Conversely, it’s important to consider that you might need less insurance towards the end of your career.
Secure insurance for what you need now, then make adjustments as you go.
Instead of treating insurance planning as a one-time event, take a look at changes to your life situation. Most fee-only financial planners do this with their clients on an annual basis. You might prefer to avoid overpaying for coverage in your younger years. Also, you have the opportunity to add additional policies that complement your needs. That way, you aren’t stuck with one large policy that feels more like a ‘one-size, one-time’ solution.
While this doesn’t address every insurance detail, it does cover one important fact: SGLI probably isn’t enough insurance. For most people. Once you’ve hit your first life milestone (such as getting married, having a child, or reaching a significant career accomplishment), you’ll probably need more. Part 2 looks at the contributions of the military spouse. Although Family SGLI (FSGLI) covers spouses for up to $100,000, this is an area where you might need more than you think.