 Personal finance practice problem using OneNote. Life insurance calculation tools. Prepare to get financially fit by practicing personal finance. You're not required to, but if you have access to OneNote, would like to follow along. We're in the icon of the left-hand side. Practice problems tab in the 10131 life insurance calculation tools tab. Also take a look at the immersive reader tool. The practice problems typically in the text area too with the same name, same number, but with transcripts. Transcripts that can be translated into multiple languages either listened to or read in them. Information's on the left-hand side. We're reviewing tools that we might use to calculate how much life insurance we may need. Noting that in prior presentations, we look at online calculators often offered by insurance companies on their websites. Noting that they asked for different data input often provided different data output, which is not surprising given the fact that there are many different angles that we can approach the life insurance calculation from. So what we would like to do is gather those tools and look at which ones would be most appropriate for our particular situation and then do our calculation possibly using these online tools as a guide to see if we're kind of in the bull park. So keeping that in mind, that's what we're doing here. We're basically looking at the kind of tools that we can put together and we'll put some of them together in a more comprehensive problem in future presentations. So the information, we got the wages. So we're gonna say a 60,000. We're gonna say the earnings rate 5%. So if we were to save, in other words, our return, we're gonna say it's 5%. Years, we're gonna say our 10. And we'll see that shortly. College costs are, we're gonna say 40,000. We're gonna imagine five kids. We're gonna imagine inflation at 3%. And then we'll deal with a mortgage later on in our calculation. So the first thing we're gonna think about, and remember the main idea you wanna keep in mind would be that I can break down the insurance company needs, say for a spouse, for example, into different kind of cash flow needs. The primary one being, how much do they need in order to calculate or get by on a year by year basis? How much cash flow do they need? And how many years do they need that for? Then we can add on to that other kind of calculations which might act differently in terms of how we would calculate it. For example, one-time costs, such as like an emergency fund maybe, or such as the funeral expenses. And then we might have goal-oriented costs, such as the college tuition, which they don't need every year. So we would wanna calculate it possibly differently if we're trying to get more precise on it, or say retirement goals, for example, or goals for say an aged parent or something like that that's gonna need care in the future, medical costs, for example. Those are goal-oriented things, and you're gonna have to calculate them a little bit differently. So the first thing we looked at is just kind of the calculation for the needs on a cash flow basis. The easiest way to do that would be to say the wages, although you don't have to take the wages, you could say that you're gonna take the expenses, for example, and pick that as your starting line number. Then we're gonna need the number of years. Now we talked about a few different ways you could figure the number of years. How many years are they gonna need that cash flow if you were to pass away? We can calculate that on how many years we have until retirement, how many years they have the spouse until retirement, how many years until a kid reaches like 18 or something like that. Now remember, you might be saying, well, after the kid reaches 18, I still have other costs that I might wanna help out with, possibly like college tuition, possibly like retirement, or those kind of things, which we might tack on on top of them because they behave differently in terms of how we're gonna do the calculation. So this number, or you can use just kind of a heuristic of like seven to 10, I have seen as a general kind of rule of thumb calculation. Now that gave us the insurance needed, that would be 600,000. In this case, you could keep that number, or you might say you could use a heuristic type of number saying, well, really I'm not gonna be around, so they're not gonna need the full 60,000 if I was to die, for example, because I'm not there. And if they were to get a lump sum at the point of death, they could invest it and earn enough in order to spend enough. So we might use some kind of fraction, for example, 70% in this case, to get to 420,000. 70%, we just use that as a rule of thumb type of number. So now we're at the 420,000. So you could use either the 600 or the 420 depending on what you're, again, it's not a perfect science, we're just estimating into the future. Estimates are inherently imperfect. But noting that, then another way we might approach this, just note that, obviously, when you're looking at this 420,000, if they get that in a lump sum, the idea would be maybe they could invest that and say, get a return on it. So that would be good. Another way you can look at it is to say, well, how much would I have to get in a lump sum amount in order to get the wages at some point? Meaning it would be great if I can basically put enough, they get enough at the point of my death so that they would get from the earnings the amount that they would need for however long they need it. That would be a higher, we're gonna come up to a higher number, of course, with a calculation like that, but it looks something like this. We could say, okay, the life insurance needs are, this is gonna, we're gonna back into this number. I'll do the calculation in reverse here, because I would usually say, how much would they need? This would be the unknown 1,200,000. And then we'd have the earnings, we're gonna assume that they earn, we said 5% of un-earnings in order to get 60,000. So how much would they need in a lump sum in order to invest it and just live off the investments for however long they need? Obviously, it would be a lot more we're at the 1,002. So to do that calculation, this times this would be that. So if I was to do my algebra, it'd be the bottom line was known, 60,000 divided by 0.05. I'm sorry, let's do that again. It would be the 60,000 divided by 0.05. It's gonna be 1,200,000. And then of course, you could double check it, taking the 1,200,000 times 0.05. That's gonna give us the 60,000. So if we wanted them to be able to just take, at the point of death, 1,200,000 and invest it, hopefully earning 5% on it and then earning the 60,000 cash flow and what they would need, they'd never need to touch the 1,200,000 and they hopefully would have the cash flow for however long basically they needed. So obviously that's a much higher number. We can do the algebra and calculate it this way, 60,000 times the 5% would be the 1,002. So again, that of course would be a much higher number than the other. And so the next thing we might say is, well, let's pick up then the idea that they're gonna need this 60,000 each year, which again, you could say based on your wages or you might do it on a needs basis approach you might be taking, for example, the expenses. And then you'd say, well instead of just multiplying at times the 10 years, maybe I use a present value calculation to think about the lump sum that they would need in order to receive the 60,000. So one way we can do that, we'll first look at it just looking at the earnings, assume they earn 5%, we're not gonna take into consideration the inflation right now, we're just gonna take that 5% and see how much they would need in order to be able to pull out from like an annuity standpoint, 60,000 each year. So that would be a negative present value, the rate we're gonna say is gonna be that 5%, the number of periods and I'm gonna do this fast in terms of interpreting this present value because we'll do it in Excel. So if you wanna work it in Excel, great tool to use in Excel. And then the number of periods, the number of periods we said is gonna be 10 and then we're gonna say that it's gonna be the payment because it is an annuity would be that 60,000 there and that's gonna give us the 463,304. So you could see that's kind of in between the 600 and the 420 we did with like the heuristic, just 70% approach up top. So to prove that, we'll prove it, we'll think about it a couple of different ways. One, we could say, well, what if we think about, let me double check this in terms of the earnings, we could say, okay, let's take the 463,304 and then if they were to earn 5% on it, we could say, all right, 463,304 times 0.05, that would be 23165 about and then they're gonna take out each year 60,000. So now they got the 463,304 plus the 23165 minus the 60,000. That gives us the 426,469. If they took out 60,000 each year, we're gonna say, okay, now next time they're gonna earn this times 0.05, another 21,323 on average, the earnings of course are not perfect. We don't know exactly what's gonna happen, but that's gonna be it. And so we're gonna say, there's that. And so if I say then we were at the 426,469 and they earn 21,323 minus the 60,000, that will give us the 387,793. And we can repeat that down the process and we can say, okay, that's how much we would need. We kind of prove to ourselves in essence, that's how much might be needed in order for them to be able to pull out the 60,000 each year instead of just taking the 60,000 times 10, which would be 600,000 because they can invest it. Now you can calculate that different ways here. So you might take say the present value, like I could calculate the present value, the same way I did here for 10 periods at zero, and then calculate the present value for nine periods and eight periods for example. And so that's another way that you can kind of do this calculation. And this is gonna be useful or could be useful because you might be saying, hey look, as I get closer to this 10 years, which could be like when the child reaches 18 or it could be say when I get to retirement or when my spouse gets to retirement, then they're not gonna need as much of this cash flow, because you only need it up until that end point. So you could try to think about your term life insurance which could decline over time. The amount could decrease as you get closer to retirement or whatever that goal is, your kid reaching 18. And again, this doesn't need to be the only component of your calculation because you might add on to it other components like goals oriented things, such as tuition and so on. But you could take into consideration the time value of money, possibly get into term life insurance that goes down over time. And so that's the idea of having this breakout on a per year basis, as opposed to kind of this generic calculation, which is really only static. It only really makes sense for that one point in time. As you get older, hopefully as you go over the hump of people being dependent and being more in debt possibly due to mortgages and whatnot, then you would think that you would need less life insurance at some point because you're hoping that you're making other people not dependent upon you, but independent from you as you get older and you would need less life insurance at that time possibly. So then let's, now this is not quite perfect because if you're saying this is the 60,000 that they need, then they might need due to inflation more than 60,000 as inflation goes up. So we could try to take that into consideration. So now let's do that for our next tool. We're gonna imagine they're gonna get a return of 5%, but we're imagining inflation is like 3%. Now 3%, where do you get that number? 5%, we're averaging a reasonable rate of return. And 3%, the Federal Reserve shoots for inflation to be between like one and 3%. So if they're doing their job properly, it should be around there, but it's possible that it could go outside of that. So you could use a larger number or something like that. Same with the earnings, hopefully you get earnings maybe more than 5% or you might wanna use a more conservative 3% or 4%. But we're gonna use these. Then if you use the present value, I'm not gonna base it on the 5%, but rather the real rate of return, the 2%, because they're gonna earn 5%, but 3% has been eaten up by the fact that they're gonna have to spend more to get the same basket of goods because the value of the dollars decreasing. So present value, we're gonna take the rate which is now 2%, the number of periods will still be 10 and the payment will still be the 60,000. So now we get the 538, 955 instead of this one 463, 304, because we were basing this one on them being able to earn 5%, not taking into account the inflation. So now this one gets a little bit more complicated to prove. So we'll prove it, basically just prove the present value calculation works and then we'll try to explain it in a little bit more detail in terms of what's actually happening. So you could say, so in other words, this calculation is really only correct for that period zero. If we want a declining balance calculation like we did before, we're gonna have to get a little bit, you know, we'll have to think about that a little bit more detail. So let's do this first. So we're gonna say, there's the 538, 955. And now let's imagine we multiply that times, we're gonna say they got the 538, 955 times the .05. So that's gonna give us, then hold on a second, is that what the earnings were? Yeah, the .05, yeah, but hold on a second, I'm doing it in terms of 538, 955 times the real rate, .02. So there's the 10779, they're gonna pull out 60,000. So that means that we've got the 538, 955 plus the 10779 minus the 60,000. And so we got that process. And again, we do that all the way down. So this would be the earnings minus the 60,000. Now, the reality of the situation is the earnings we're expecting in terms of actual dollars, we're expecting the earnings to be 5%. And then the payments, we're actually expecting them to not pull out 60,000, but more than 60,000 as time passes because they're gonna need more money to pay for the same stuff. So it's gonna look more like this one over here. So this one kind of proves the calculation which is correct as of period zero because if I was to do this all the way down and we get down to zero, but closer to what's actually happening is in terms of the actual values of dollar value and the future value of dollars, we're expecting that when they start off with this 538, 955, we're gonna multiply that times .05 and that's gonna give us actually 26,948. And then they're gonna take out not 60,000 a year later because to buy the same basket of goods that 60,000 is gonna have inflation, which is 60,000, we said times .03. So 18,000 more plus the 60,000, there's the 61,000. So now in terms of future value dollars, they should have 538, 955 plus 26,948 minus 61800 and that would give us the 504,103 in terms of future value dollars. So notice it's kind of different than over here because this one's really only correct as a period zero. And so then we're gonna say, okay, so now we've got the 504, 504,103 and then times the .05 they're gonna earn, there's the 25,205, but then the 60,000 is gonna have to go up again because they're gonna need more money to take out in order to buy the same stuff. So 61,800 times .03 is another 1,854 plus the 61,800. So now we're at 63,654. So now if I take this 504,103 plus 25,205 minus the 63,654, we're at the 4,654. And if I do that all the way down, we're not exactly zero because of the way we had to kind of, we broke this out on a year by year basis, but you get an idea in terms of real dollars of what's happening. So you could kind of base this outer column as that declining balance calculation instead of this one, because this one's only correct as a .1 if you want like a declining term balance kind of calculation. Or you could recalculate this, I didn't make an example of it, but you can use this calculation up top for each period. So it was 10 periods and then nine periods and eight periods kind of like we did up here. And so then you can get that declining amount, how much is needed, in other words, as you get closer to that endpoint, which possibly could be when the child gets to 18, when you reach retirement, when your spouse reached retirement, whatever that goal is. And you might be able to tailor your term insurance to decline as you get closer to that goal, which could make it more affordable. Okay, so then you might have like college costs, which you could tack on to this. So that's a goal oriented thing. So if you're trying to calculate a college cost, you might do something like, okay, well the current cost, let's say it's 40,000. I'm just making the number up 40,000 years until college. How long do you have to be until you got to pave that 40,000? Let's say that the 18 is when they're gonna start college, when they're 18, let's say, it might be, you know, whatever we'll set. Well, you're going to two years of the city college, if you're going at all, I don't know, 18 minus five, and that's gonna give us, let's say the kid's age is five. So we got 13 years before they start college. Now you might try to say, okay, well the college, you could get more complex and say, well, the college is gonna last four years, let's say, and you could do an annuity of how much they need each of those four years. But let's just say as of a lump sum, we need when they're starting college that much money. And so that's gonna be the goal that we want. So we've got 40,000 and we've got the 13 years so we could have the future value, what will be the future value dollars that will be needed. So we're doing a future value calculation here because the 40,000 is in current terms, but the actual goal we want to get to is gonna be the 58,741 because we're doing, we're gonna say how much is it gonna cost 13 years later given the fact that we have the 3% inflation. So this would be a future value calculation, 3% inflation, 13 years into the future, we're gonna need 58,741 to pay for the college as of the start of the college, we'll say. So now we can think about, okay, well how much, if they got a lump sum at the point of death, how much would they need if they can invest it and get 5% return in order to reach the future value of the 58,741. So we could say like if I died today and it takes 13 years, then notice we calculated this number based on inflation to get the future value based on inflation, based on the increase of the cost of the college, but here we're gonna take, we're gonna say let's take the present value of that 58,741 based on the 5% the earnings because I'm assuming we can earn 5%. So we'll take the present value of that one lump sum. So notice I have the rate, which is gonna be the 5% in essence, it's a complicated looking formula because we try to make it in Excel so I can copy it down, I won't go into that now if you wanna do it in Excel, then check it out. We've got the number of periods, which we're gonna say is 13 and then two commas because we want the future value, it's not an annuity and so that's gonna be the 58,741. So we would need then if I died now 31,153, but what if I died a year later, right? So that's a static number. So as this one goes opposite to what we did before, which means that the life insurance would go down if we have a goal oriented item, as we get closer to the goal, they're gonna need more in order because they got less time for them to save up and get earnings on it. So a year later, now we would have the present value of the rate, which I'm gonna assume a 5% earnings. The number of periods is now 13 minus one, right? Because now a year has passed and then we're gonna say that the future value is still the 58,741. So again, you could do this all the way down and say, well, as I get closer to that point where college happens, if I died right before they went to college, then they're gonna need the whole 58,741 in order to pay for the college because they can't earn on it. So notice this one's doing like the opposite. This goal oriented item's doing the opposite as this one up top. If we were to combine them together, then again, you can figure out kind of like the declining balance. So you gotta think about these things separately because they behave differently and you can try to figure out the big one, which is this one, how much do they need per year and then think about the goal oriented ones and possibly add that in layering, your needs that way using those tools. So this calculation here to kind of prove that, that 31, here's the 31, here's the earnings on the 31 at the 5%. So 31, if I took the 31,152 times .05, you get the 1558. And if I did that all the way down, we'd have the 58,741, which we said is how much they're gonna need. So that's kind of the idea. Okay, and so this kind of goal oriented thing, you might do this, for example, also with if you wanna calculate your spouse's retirement, cause that's another goal oriented thing and try to help or pitch in for that or if you had like an elderly parent that's gonna need medical costs, that you think it's gonna be a lump sum in the future, same kind of calculation for those kind of things, they behave differently. And then the other one that could be useful is to calculate your amortization table. I won't go through the whole thing cause we've seen it in the past, but the loan, the mortgage is obviously one of the big components. So if you calculated your amortization table or possibly just got it online, I still think it's good to recalculate it in Excel because then you can break it down from a month by month calculation to a year by year calculation, which is much more useful. So oftentimes, as part of your calculation, you might try to tie your term insurance to the loan balance. And there's a couple of different ways you can do it. You might say, well, you know, as I get older, I'll owe less money because I'll be paying off my big debt, which is gonna be the mortgage. So again, you might say that I wanna have my life insurance decrease as basically the mortgage balance decreases. And you might try to figure out and allow that if you were to die, I'd like them to just be able to pay off the mortgage. That would be great. Or you might try to figure out the cash flows, of course, on a year by year basis. And then use that as part of your calculation, not to have the calculation of them paying off the whole thing possibly, but having the cash flow in a year by year basis until the mortgage is paid off in that way. So that you can use the mortgage again, the major debt oftentimes as another calculating tool, possibly starting off with the amortization table, which I'll show you how to build online if you wanna do this in Excel, and then break it into a year by year calculation, which is often more helpful, especially to see that debt where the debt would be, the balance would be on a year by year calculation. And then we can use that in various ways to add on to our life insurance calculations. So next time we'll take some of these tools and we'll do an example of like a comprehensive problem, how you might kind of compile them together in a life insurance calculation.