Life’s Persistent Questions #5: Can We Make Life Insurance the Income Replacement Solution It’s Meant to Be?

By: Eric Sondergeld
9/10/2024

Check out almost any life insurance needs calculator and it is obvious that the largest component of the answer is an amount representing some multiple of income. Amounts are also typically included for immediate payoff of outstanding debt, college education, final expenses, and even items such as childcare and an emergency fund.

Other than digitizing these formulas in the form of online calculators, the theory behind them has remained largely unchanged for decades. Before that, we likely used rules of thumb of income multiples, many of which are commonly used in practice today. I see two main problems with this approach to estimating life insurance needs. First, the amount becomes quickly outdated. As time passes, fewer years of income replacement are needed, children may no longer be dependents, incomes have grown, debt gets paid down, or a larger home is purchased with a bigger mortgage, etc.  Second, if income replacement is indeed the largest component of the life insurance benefit, then why is the benefit not paid as an income?

There’s a way to address both of these issues. The first requires an admission that there’s a fair amount of double-counting going on in the current approach. If life insurance provides replacement income (whether paid in a lump sum or over time), that income presumably is currently being used to pay down debt, save for children’s college, etc. I can’t believe nobody has stopped to ask, “why do I need to replace my income AND some of the things it pays for?” or “Why is 10 years of income replacement the norm?” The second is to change the terminology from “death benefit” to “income amount.” If life insurance is to truly be an income replacement product, we need to present it and talk about it that way. For products intended to primarily replace income, we might eliminate the term “face amount” from our vocabulary. Instead, the conversation should be about how much income is needed and for how long.

The how much starts with your annual income and subtracting an amount for taxes (since the death benefit is not taxable) and perhaps a bit more since the income won’t need to support the insured after he or she has passed. In addition, an assumption for income growth can be incorporated. The length of time could be a number of years or, preferably, to a specific age. For example, a 40-year-old whose youngest child is 10 might expect to support that child until they reach age 22 and are out of college. That parent might buy coverage that replaces their income until they are 52. Another example is to replace income until an expected retirement age if there are one or more members of the household (or household expenses such as mortgage payments) reliant on that income. The life insurance benefit would be expressed as a monthly amount, just like with disability income insurance.

In fact, all the above ways of defining the benefit already exist within the disability income market. And like disability income insurance, the concept of face amount is a foreign one. The only remnant of one in this approach might be allowing for a modest lump sum benefit to cover final expenses. An added benefit is that the life insurance conversation dovetails nicely with the disability income insurance conversation. Creative companies could even develop a combination product that replaces income until retirement age, potentially at different amounts depending on whether the insured is disabled or dead.

Presenting life insurance as an income replacement solution offers the following additional benefits:

• The death benefit and its intent become clearer to beneficiaries, as it’s simply a continuation of the income that has supported them all along.
• Beneficiaries don’t have to figure out how to manage a lump sum payment, something people are generally not great at doing.
• It simplifies the conversation and removes complicated factors like amounts for debt and education and having to decide whether the income replacement (that is paid as a lump sum) should last (or more accurately, represent) seven, ten, or twenty years.

Making life insurance the true income replacement vehicle its meant to be requires a shift in thinking, benefit calculation, and terminology. Its positives are clear and can make purchasing life insurance easier for customers.