With the earnings multiple approach, the goal of having life insurance is earnings replacement. This approach has the goal of replacing the annual salary stream of a bread winner for a certain number of years, or until the children are raised and the spouse is financially stable and retired. Normally, an amount of five to fifteen times your gross salary is recommended. Generally, most insurance companies will not insure an individual for more than twenty times his or her annual income. Be aware that the lower the general interest rates, the higher the multiple needed. There is a three-step process for using the earnings multiple approach.

1. Adjust the pre-incident salary down to compensate for the reduction in household expenses. Generally, a family’s expenses decline in a predictable manner in the event of the death of an adult family member. The larger the family size, the less the percentage of total family expenses will drop (see Table 1).

Table 1

2. Choose the appropriate interest rate to match the assumed after-tax and after-inflation earnings on a policy settlement. Interest rates affect insurance policies in that the higher the market interest rates, the more that can be earned on investments, including money paid by an insurance company. If you think market interest rates will be higher, your beneficiaries will not need as large an insurance settlement as would be necessary if market interest rates were lower.

Once life insurance proceeds are paid to the beneficiaries, the proceeds should be invested with the goal of providing a specific amount of money each year, or an annuity, to meet the beneficiary needs and expenses. Additionally, an annuity could also be purchased or an annuity settlement option in the policy elected, which would guarantee a specific amount each period for a specific number of periods or years. Investing these funds will ensure that funds are available to pay expenses in a timely manner.

To get an idea of how interest rates and the amount needed each year are related, see Table 2. If you needed $50,000 at the beginning of each year for the next forty years and market interest rates were 5 percent, you would need $857,954 in life insurance proceeds to be able to invest in an annuity that would guarantee $50,000 per year for forty years. If market interest rates were 3 percent, you would need over $1 million in life insurance proceeds. Likewise if you needed $50,000 per year for ten years, and interest rates were 5 percent, you would only need $386,087 in life insurance proceeds. Clearly, interest rates have an impact on insurance needs.

Table 2

This table shows the amount needed to invest to obtain a $50,000 annual payment or annuity (for salary replacement) for the following years in retirement at the indicated market interest rates.

3. Determine the income stream replacement and annuity. The income stream replacement is how much money the beneficiaries will need each period or year and how long they will need that income stream. With these two inputs, you can determine the needed annuity to provide those payments. Once you have determined how much you need each period and for how long, you can calculate the amount of money needed to provide the required income stream.