The Federal Employees Group Life Insurance (FEGLI) program is planning its first open season in five years this fall. This is an important, and fairly rare, opportunity for eligible employees to review and adjust their life insurance coverage for the years to come.

Whether you choose FEGLI’s term insurance or a private alternative, you should figure out how much life insurance you need. Too little and your survivors will be left wanting; too much and you’re wasting money on high premiums. Whatever amount of insurance you choose, you should at least make sure it’s based on a sound rationale.

Rules-of-thumb calculations for insurance amounting to 10 times annual earnings or enough to pay off a mortgage rarely deliver the desired results and often leave survivors figuring out how to make do, rather than able to continue the lifestyles they are accustomed to. I find that my younger clients tend to be underinsured, while older ones tend to be over-insured. This is because it is common for life insurance needs to increase, and then decrease as financial independence is achieved.

Life insurance provides financial security to survivors, and so the survivors should be involved in decisions about coverage. In my experience, it is not uncommon for a dependent spouse to be excluded from the decision-making process and uninformed about the amount of the benefit he or she would receive should the breadwinner die. The purchase of life insurance should be made from the beneficiary’s perspective. Rather than “How much life insurance do I want for my spouse?” the question should be “How much life insurance do I want from my spouse?” For this and other reasons I often recommend that, when possible, the beneficiary of the policy own the policy and be responsible for making sure premiums are paid.

The correct amount of life insurance depends on a number of interdependent variables, including assumptions about future circumstances. You must estimate the survivor’s desired spending allowance, life expectancy, tax rates, investment portfolio and outside sources of income. Expectations for inflation, investment returns and volatility are also critical.

Calculating the amount of life insurance necessary to provide the desired effects can be complicated. The combination of values and assumptions, and hence the guidance, will be different from case to case. But it is possible to use some general results as the basis for an estimate. In the accompanying chart, I’ve provided the results of some analysis I conducted to help you get a feel for how much life insurance you might need.

This analysis tested the insurance strategy against a variety of investment market conditions and recommended a solution for the optimum outcome. Be aware this is general guidance and should be used only as a starting point for your own personal analysis.

To estimate your life insurance need, follow these steps

  • Identify areas of financial need that would be created by a death tomorrow. These can include funeral expenses, a loan repayment, the loss of income from a breadwinner or the increased living expenses needed to compensate for the loss of a stay-at-home parent. These are the needs that would be unmet by the survivor’s financial resources without the benefit of life insurance.
  • Estimate — without worrying about inflation — any immediate or short-term financial needs. These should be added to the life insurance need at face value. Also estimate any recurring annual needs and the number of years the need will last. Where a need will change over time, such as a decrease in the shortfall amount after children leave home, split the needs into separate amounts over the applicable time periods. You might decide that you would be short $20,000 per year for 10 years, and then short $10,000 per year for 10 years after that.
  • Using the chart, estimate the amount of life insurance you’ll need to cover each of the recurring needs you identified and then add them together. Add this total to the immediate and short-term amounts for the total amount of insurance you need. There is no need to adjust the chart amount for taxes since life insurance proceeds are usually received free of income tax. You can interpolate between amounts in the chart, if necessary.

In developing the chart, I assumed that the survivor would invest the life insurance proceeds in a moderately aggressive portfolio of low-cost stock and bond index funds. I also assumed that the portfolio would be subject to federal and state (Virginia) income taxes and that overall inflation would average 3 percent per year during the withdrawal period.

Your own estimates should be adjusted to compensate for changes in these assumptions. For example, if the survivor is a conservative investor, you should adjust the amount of insurance upward somewhat to compensate for lower expected returns.

It is important to note that fixed life insurance values are diminished by inflation over time. So a fixed $100,000 death benefit purchased today won’t have the same value 20 years from now. You should review your life insurance coverage every few years to keep it current. An advantage of FEGLI is that, to the extent that it’s based upon the insured person’s earnings, most of the death benefit will likely increase with inflation as the underlying earnings are adjusted from year to year.

While not a substitute for individual analysis, the chart is the result of advanced analytic techniques and should help you to improve your decisions during FEGLI open season or any time you are considering buying life insurance. If you’d like more accurate estimates, you may want to consult a qualified professional adviser.

FEGLI’s open season 

Federal and U.S. Postal Service employees in eligible positions will be able to enroll in the Federal Employees’ Group Life Insurance (FEGLI) program or increase or change current coverage without having a physical or answering questions about their health during a month-long open season that begins Sept. 1.

The FEGLI program consists of basic life insurance coverage and three options that include coverage for up to five times an employee’s base salary plus coverage for family members. In most cases, a new employee is automatically covered by basic life insurance. The types and amounts of coverage available are not changing.

The earliest newly elected coverage will be effective is Sept. 1, 2005.

The Office of Personnel Management plans a special FEGLI 2004 open season Web site that will contain an election form and more information.

Written by Mike Miles
For the Federal Times
Publication June 28, 2004