A reader was in touch recently confused about life insurance. He is retired, the mortgage is paid off. How much life cover should he have, he wondered? It’s a good question but the less than helpful answer is “it depends”.
How much life insurance you need depends on your personal and financial circumstances. How much you pay depends on a numbers of factors – your age, general health, habits such as smoking or heavy drinking and the amount of cover you require.
You can get policies that pay out after a certain number of years, ones that last as long as you do, products that pay out on the first death in a couple, and those that pay out an amount at that point while continuing a level of cover for the surviving person.
The bottom line is that you want to put in place cover that will ease or erase the financial burden on loved ones left behind should you die.
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For younger people with no dependents, it is not really an essential. Insurance companies will try to tempt you with “whole of life” policies, arguing that the premiums on such policies can be very low if you sign up in your 20s compared to what they might be in your 40s.
These policies pay out a fixed sum agreed at the outset and the premiums can be fixed. Because someone in their 20s can typically expect to live for another 60 years or so, the monthly premiums are very manageable but will be paid for a long time.
In that time, inflation will erode the real value of the lump sum covered. Put simply, €1,000 is likely to buy far more today than it will for those you leave behind in 40, 50 or 60 years’ time.
You can index the cover but that will also mean premium reviews and these can get very expensive just as you get to the point where your income is reduced in retirement. And if you stop paying, the cover ceases even if you have paid premiums for 40 or more years.
Whole-of-life policies do have a place in the market but, for most people, the first port of call will be a term life policy.
As the name suggests, a term life policy promises to pay out a specific amount if you die within the term covered by the policy. That can be anything from a couple of years to 40 or more.
In real life, term policies can be most useful in providing cover for things such as the wages you will no longer be bringing into the home, especially during those very expensive years when you are raising children, if any.
One rookie mistake is to calculate what you need based on the cost of children until they are 18 years old. As anyone with adult children knows, costs can continue well into their 20s with college education and the challenge of getting into employment.
As you get older, your need for cover diminishes. The children will be reared, the income you need to cover is reduced from your working income to your retirement income.
And people often forget that they have, almost unawares, acquired a certain amount of life cover.
The biggest monthly expense for most people will be their mortgage – although the cost of childcare is certainly pushing a close second these days. However, every lender in Ireland will require homebuyers to take out a mortgage protection policy. And a mortgage protection policy is a life policy by a different name.
Mortgage protection will pay out a sum equivalent to the remaining mortgage balance in the event of the homeowner dying. Where there are two owners, they should pay out on first death.
The cover diminishes in line with the reducing balance on your mortgage.
Two things to note with mortgage protection. First, given the reducing level of cover over time, issues can arise if arrears build up on the home loan. Second, while your lender will offer to arrange mortgage protection, you will generally source the same cover noticeably cheaper elsewhere in the market with a little ringing around.
The difference in premiums may not sound big in the scheme of things but finances are usually tight anyway in the early years of a mortgage and, over time, those relatively small differences in monthly premiums can build up to a substantial sum.
The other “forgotten” life cover is death in service benefit.
Most people in work, either through the company pension fund or separately, will be covered by death in service benefit. And better still, the premiums are paid by your employer.
In many cases, these policies will pay out four times your salary if you die while still in employment. That is the maximum payout permitted by Revenue free of tax. For people on average earnings of about €52,500, that could mean a payout to your estate of €210,000.
As I say, death in service is paid tax free but it could be subject to inheritance tax depending on who benefits under your will or, in its absence, under intestacy. A spouse will pay no tax but others might well.
Everyone should check with the employer to confirm the level of death in service benefit. In terms of other life cover you might need to put in place, there is a big difference between a company that pays out the full four years of death in service benefit and others who might only pay two years.
With a mortgage paid off and up to four times your salary coming to your family under death in service, the life cover you need to pay for can be sharply reduced.
So, if you are sitting down to work it out, how do you do it?
First, you need to look at your monthly outgoings. It doesn’t need to be accurate to the last euro but find out how much are you spending on a mortgage or rent, childcare, education, health insurance policies, utility bills, food and entertainment.
How much of that is covered by other policies, such as a mortgage protection policy? Is your spouse or partner bringing income into the home?
For the sake of an example, let’s assume your monthly bills amount to €6,000, of which €2,500 is a mortgage payment covered by mortgage protection. Your partner works and brings in €2,000 a month.
The financial gap in this case is €1,500 after your partner’s earnings and the mortgage costs are excluded. It makes sense to build in a buffer – say €500 to cover unexpected outlays. That brings the “gap” to €2,000 a month, or €24,000 a year.
Then you need to figure out how long you need to make provision, or bridge that gap: what age are the kids when you take out the policy; how far away are either of you from retirement, etc.
If you were to take out cover of between €450,000 and €500,000, that money would be paid out on your death and could be invested. Assuming a return of 5 per cent annually, it would give annual income of between €22,500 and €25,000 a year.
If you rent rather than own your home, the gap widens to €4,500 a month, or €54,000, and the cover you would be looking to put in place increases to about €1.1 million.
There is one area that regularly falls off the radar when people look at life insurance, even when they work out numbers like above – the value of unpaid labour.
If one spouse or partner is working in the home, doing the childcare, the cleaning, the cooking, whatever, it does not show up in the numbers. However, if that person is no longer there, these are services that you may have to pay for. Where is that money coming from?
Couples where one person works in the home really should make sure the costs of paying for essential services provided by that spouse or partner are provided for with dedicated life cover. The good news is that if that is a woman – and, of course, it normally is – the premiums will be lower as they live longer, on average.
Always review your cover periodically. Circumstances change. Perhaps a health incident means you face much higher long-term healthcare or carer costs than had originally been envisaged. Or a renter buys a home so they no longer need as much cover as they had originally reckoned on.
One final thought: gold-plated life cover where there will be no financial loss of household income in the event of someone dying is great but only so far as it is affordable. Ideal cover that you cannot afford is worse than useless; you will be agreeing premiums for a product that will ultimately be of no use to you because you cannot afford the monthly payment out of your household budget and the policy will lapse. Affordability counts.
You can contact us at OnTheMoney@irishtimes.com with personal finance questions you would like to see us address. If you missed last week’s newsletter, you can read it here.
