Insurance for early retirement or financial independence – part 1

I’ve spent the last few years taking the necessary coursework to become a Certified Financial Planner (CFP). The classwork has been an interesting mix of review of topics I am already very knowledgeable about (investing, asset allocation, and retirement savings accounts) and topics I knew nothing about (estate planning, Social Security, Medicare/Medicaid, and a wide variety of insurance products).

The final class (which I am now taking) focuses on case studies. Each case study is about 10 pages of information for a fictitious family. The information includes, among other things, their ages, goals, income, expenses, assets, liabilities, existing insurance, projected educational goals, latest tax return, investment allocations, and current estate planning (wills, trusts, etc.). This amount of data is not only overwhelming, but it’s exactly what we must review when analyzing our own lives and financial positions.

Thankfully, there’s a methodology to break this process down into a step-by-step process.

R.E.T.I.R.E

The RETIRE acronym stands for

  • Risk management/assessment
  • Expenses/income
  • Tax planning
  • Investments
  • Retirement planning
  • Estate planning

Note that it’s not necessary to go through these steps in this particular order, but you’ll want to review them all to get an accurate assessment of your financial position.

There’s a lot of information out there about these areas for the average working stiff, but I’ve found there’s almost no information out there specifically for the financial independence/early retirement community.

In this series of articles I’m going to run through the RETIRE framework specifically in the context of the FIRE (Financially Independent/Retiring Early) community. After all, the risks we face are clearly different from the risks facing the average person.

R – Risk management/assessment

If I were to guess, I’d say that 99% of the blogs in the financial blogosphere focus on either expenses/income or investments. I don’t know of a single popular blog that focuses on insurance or risk mitigation.

Why?

Perhaps it’s because most people think insurance is about as interesting as watching paint dry. Or perhaps it’s because insurance, by definition, is protection against a potential future negative event. Getting life insurance means thinking about DYING. Disability insurance requires you to confront the possibility that you could face an injury or disease so severe that you couldn’t provide for yourself or your family. It’s not the sort of stuff you want to talk about with the extended family during Thanksgiving dinner. It’s a bummer.

But here’s the thing – insurance and risk mitigation can actually be pretty interesting. Not only that, but knowing that you have the proper amount of insurance is a huge relief. I know this because I just went through this whole exercise myself.

I tend to think of insurance as falling into one of two general categories:

  • Insurance to protect your income/earning power. Examples include life insurance, disability insurance, and to some extent health insurance.
  • Insurance to protect your assets. This is auto insurance, homeowner’s insurance, umbrella policies.

I’ve noticed that people tend to do pretty well with insurance for asset protection but they do a pretty poor job of income/earning power protection. In part, this is because insurance to protect assets is forced on us in many cases (your mortgage company will require you to have homeowner’s insurance and auto insurance is mandatory in 49 states), but nobody is forced to purchase life or disability insurance.

When looking specifically at the needs of the FIRE community there’s a reduced need for income protection and increased need for asset protection, relative to the general population.

Insurable risks

First I’m going to give you a bit of information about the aspects of insurance that I find interesting (and hopefully you will as well) – not all risks are insurable. In order for a risk to be insurable it has to satisfy these criteria:

  • The risk must be accidental. Car accidents are, for the most part, accidental. They are an insurable risk. Turning 65 is entirely predictable, which means you can’t insure against turning 65. Otherwise, people would just wait until one day before their 65th birthday and purchase “65 insurance”. This would clearly not be a sustainable business money for insurance companies.
  • The chance of a loss must happen at a predictable rate. For example, an insurance company might know that the average house has a 1 in 100,000 chance of suffering a fire each year. The insurance company can then use that information to predict the losses in a large pool of customers and set premiums appropriately. House fires are an insurable risk. On the other hand, there is no way to predict if/when a volcano will appear or the chances that your house will be destroyed by lava. As a result, those risks are excluded from typical homeowner’s policies.
  • The loss must be definite. It has to be clear to all parties if/when a loss has occurred. It’s possible to insure against collision damage to your car because it’s clear to both you and the insurance company when your car is damaged. It’s not possible to against the chances of your child being a disappointment, since that definition of that would be different for everybody.
  • Losses must be independent. The chance of you getting into a car accident is not increased or decreased by somebody else in another town getting into a car accident. The chances of you getting cancer are independent of some other random person getting cancer. These are insurable risks.
  • The loss can not be catastrophic. That is, if the loss is so large that it would bankrupt the insurance company if a loss occurs then that risk isn’t insurable.

If a risk doesn’t meet the above criteria then it’s not an insurable risk. In addition, the more uncertainty there is in the above areas the higher the relative pricing of insurance would need to be.

A major issue in insurance is adverse selection. If one party to a transaction has more information than the other than they can use that information asymmetry to their advantage. For example, let’s say that when you bought life insurance the insurance company was not allowed to ask for your age, gender, or health. Instead, they had to charge everybody the same premium. Who would get insurance? Old people and sick people! This means that the insurance company would need to price the insurance policy so it would be appropriate for old people and sick people, which means it would be so expenses for the young and healthy that no young and/or healthy people would buy insurance.

There are a variety of ways to address adverse selection. One way is the principle that insurance should not leave you better off than before an insurable event happened. For example, if your auto insurance replaced your car with a nicer/better/more expensive car after a collision you’d have an incentive to intentionally crash your car.

Another way insurance companies address adverse selection is to gather as much relevant information as possible so the policy can be priced correctly. If you want a life insurance policy you’re asking about age, gender, smoking history, occupation, recreational activities, etc. A 85-year-old man who smokes 3 packs of cigarettes a day would have a higher risk of dying in any given year than a 25-year-old woman triathlete who doesn’t smoke. Insurance companies charge the former a higher yearly premium than the latter.

Life insurance

Everybody knows what this is – if you die then somebody else is paid a chunk of money. Pretty straightforward. Getting life insurance is surprisingly easy. You get calculate how much insurance  you need and for how long you need it, then you get a few quotes. If you’re in great shape you’ll be eligible for better rates, but you’ll likely need to take a physical and do blood/urine tests to qualify for those rates.

The hard part is figuring out how much life insurance you need, and the answer is: probably a lot more than you think.

There are tons of different formulas. Some people use a fixed multiplier of your salary (5x or 7x your salary). This is both useless and stupid. Anybody advocating this to you either is incompetent or just doesn’t want to (or can’t) run through the calculations below.

There are really only 2 reasonable ways to calculate you insurance needs:

Income replacement

This is how much money you’d need today to equal your future steam of income. This relies on a discount rate, which can be thought of as how high your expected return would be on money invested today. I usually use something relatively conservative like 7%.

The easiest way to calculate your income replacement level is to use the NPV (Net Present Value) function in Excel.

Net Present Value calculation

Here’s an example – I’ve set up a NPV calculation for replacing 10 years of income. In this example I’m assuming a starting salary of $100,000/year, and this income grows by 3%/year. The salary grows from $100,000 in the first year to $130,477.32 in the last year.

The NPV formula is at the top right of the picture. The formula is “=NPV(9%, C2:C11)”. We are using 9% as the discount rate and we want to calculate the NPV for the 10 cells holding the yearly salaries (C2 through C11).

Note that if you actually add up the salary for the 10 years you get a total of $1,146,387.93 but the NPV is only $720,525.33. Intuitively this makes sense. Money today is worth more than money tomorrow, and $720k or so today will grow to roughly  $1.46M over the course of the 10 years.

So, if you make $100,000/year, you expect that value to grow at 3%/year, and you want to replace that salary you’d need about $720k of life insurance. I reran the calculation for the NPV of the salary through 67 years old (28 years instead of 10) and the NPV is $1,325,199.38. At first glance this seems strange. We have tripled the number of years of salary that we need to replace but the NPV (and by extension, the amount of life insurance required) only went up by 84%.

But if you stop to think about it, this makes sense. A dollar today is worth a bit more than a dollar next year, but it’s worth a LOT more than a dollar in 28 years. Just for fun, I reran the same calculation for 50 years and NPV is only $1,609,561. That means that $1.6M today, invested at 9%, will provide the equivalent of $100,000 in salary (assuming the salary grows at 3%/year) for 50 years.

This is the easiest and quickest way to calculate your life insurance needs. With this amount of insurance your dependents will be in exactly the same position financially as if you hadn’t died.

Needs analysis

This is more complicated than the income replacement method above. Basically you run through your expected expenses (college for the kids, paying off the mortgage, etc.) and add them all up, then discount back to the present time. Again, we can use the NPV() function in Excel to make this a lot easier.

The big question in this analysis is what needs you want to cover with life insurance. Education for your kids (if you have any) is pretty straightforward. You’ll probably want to pay off the mortgage as well – that will make the surviving spouse’s life much easier. And if you have kids and your spouse doesn’t currently work you’ll probably want to leave enough money so they can continue their life as is without your spouse needing to work.

A few notes about types of life insurance

There are lots of different types of insurance – term, whole, universal, variable universal life, etc. Here’s the reality – you’ll almost certainly only need term-life insurance. The only people who need any of the other types of insurance are people whose estate will exceed the estate exemption ($5.49M per person in 2017). Why? Well, one of the main benefits of life insurance is that benefits are received tax-free. Yes, there are some exceptions to this rule, but for the vast majority of cases it’s true.

If somebody tries to tell you (or tells you to buy) something other than term-life insurance they are probably trying to rip you off. This is especially true if you’re saving and investing for FIRE.

Life insurance for the FIRE community

The average person seeking FIRE, by definition, has a shorter expected working career than a typical person. If the average person works from 21 to 65 their working career is 44 years. If instead you plan to retire at 40 then you only have a working career of 19 years. You only need life insurance until the age when you expect to retire or reach financial independence. If you’re 30 and expect to hit FIRE at 40 you would only need a 10-year term-life policy whereas the average 30-year old might need a 35-year policy.

This is a big advantage for us, as a 10-year policy is about 25% cheaper per year than a 30-year policy. Not only do we need to pay for insurance for fewer years, but the insurance is cheaper for the years we have it. Cool.

If you’re not sure when you expect to hit FIRE (and the further away it is the less accurate your estimate is) then get a term-life policy for a bit longer than you think you’ll need. You can always stop paying a term-life policy (effectively cancelling it), but it could be quite expensive (and difficult) to extend a policy for a few additional years.

So, if you’re 35 and expect to retire at 45, I’d recommend getting a 15-year rather than a 10-year term-life policy.

Conclusion

If you have dependents of any kind you need life insurance. Even if you have no kids and your spouse works it’s still likely that your income is critical to maintaining your spouse’s quality of life. You pay half the rent, you share a car, etc. If something happens to you their work would suffer or they might need to take extended time off (or quit work entirely). Life insurance will give them the financial resources to making dealing with your death a bit easier.

If you have kids then the need is even more important. Not only do you need to replace your income but your labor around the house as well. If you’re not around your spouse will need to hire a babysitter and/or bring home dinner more often. Even a stay-at-home parent needs life insurance. After all, if you’re not around the surviving spouse is going to have to pay for child care so they can work, and anybody who has a kid knows that child care is EXPENSIVE.

Life insurance is easy to buy and it’s something you’ll only need to do once.

 

Questions for you – do you have life insurance? If so, how much and for how long? How did you calculate how much insurance you need?

4 thoughts on “Insurance for early retirement or financial independence – part 1

  1. I have to admit, I think even term insurance is a mistake for most people. If you have kids, you have very generous SS survivor benefits. In addition, if you are aiming for FIRE, you have much lower spending than “average” people, so it’s best to cut out the middle man and invest those premiums saved.

    1. I’m going to have to strongly disagree with you here. First, I guess the viability of living on Social Security benefits depends on your definition of “generous”. In general it’s going to max out at around $2,000 for each kid and $2,000 for your spouse, with a max of just over $5,000 for a given family. I agree that’s pretty generous, and a married couple with 2 kids would probably be ok if the main wage earner died and the remaining spouse and 2 kids received $5k/month of Social Security.

      But here’s the thing – receiving the max would require you to be earning the maximum amount of Social Security income, which means $120k+. That means that unless you’re already saving 50% of your income you’re currently living on more than $60k/year. Living off Social Security survivor benefits would require your lifestyle to be decreased.

      For some people that’s ok. Personally, I don’t want to rely on Social Security. Since SS survivor benefits aren’t means tested there’s no reason to not also have enough life insurance to ensure your family’s standard of living.

    1. I’m glad this information helps. Are you just starting out in your career or are you somebody who has been in the workforce for a while but is now concentrating on saving and investing?

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