Life Insurance: An Extra Income Stream For You?

Life insurance is a crucial financial product that provides peace of mind and security for individuals and their loved ones. While the primary purpose of life insurance is to offer a safety net in the form of a lump-sum death benefit, some policies also offer an income stream feature, known as a family income policy or rider. This innovative approach to life insurance aims to replicate the lost income of a family breadwinner by distributing the death benefit in monthly instalments over a set period. This income stream approach ensures that beneficiaries receive a steady flow of funds to maintain their standard of living and cover essential expenses.

Family income life insurance

When taking out a family income life insurance policy, the policyholder decides how much money will be paid out each month and for how long. For example, a policyholder may decide they want their family to receive $5,000 per month to replace lost income after they die. If the policyholder dies five years into a 20-year term, the insurer will pay out $5,000 per month for the remaining 15 years, totalling $900,000. However, if death occurs 15 years into the policy, the same monthly amount will only be paid out for the final five years, resulting in a total payout of $300,000.

The benefit of this type of policy is that it provides a stable income stream for beneficiaries, making it easier to manage than a large lump sum. This is particularly useful for young families who are dependent on the income of the policyholder. Additionally, the policy is structured so that it provides the most coverage early on in the term, when it is likely to be needed the most.

However, a downside of this type of policy is that the longer the policy is active and unused, the less benefit the beneficiaries will receive. Furthermore, due to the decreasing nature of the benefit, the policy may not provide as much financial support as beneficiaries may need.

A family income rider can also be added to a standard life insurance policy, providing the option of a monthly payment in addition to the lump-sum death benefit.

Pros and cons of a family income policy

A family income policy is a type of term life insurance policy. The policy is active for a certain number of years (the term) and the insurer pays a death benefit to your beneficiaries if you die during the term. The death benefit is paid out in monthly instalments over a set period rather than in a single lump sum.

Pros of a family income policy

A family income policy replicates getting an income from the breadwinner, so it’s more true-to-life and easier to manage than a lump sum. The policy is also structured so that it provides the most support early on in the term, such as when your children are still young, tapering off when you are more likely to have saved for retirement and paid off debts.

Cons of a family income policy

The biggest downside of a family income policy is that it decreases in value the longer you’re alive. Your beneficiaries receive instalments depending on when you pass away, so they’ll get less benefit the longer the policy is active and unused. Even if you need less coverage as you age, a life insurance policy with a stable value will still be able to cover existing debt or help your family maintain their lifestyle if you pass away.

How to calculate the human life value

Income stream from life insurance refers to the method of payment of the death benefit to the beneficiaries of the insured. While most life insurance policies pay out the proceeds as a tax-free lump sum, some policies, such as family income life insurance, distribute the death benefit in monthly instalments for a set period. This replicates the income from the breadwinner, making it more manageable for the beneficiaries.

Human Life Value (HLV) is a way to calculate the amount of life insurance a family would need, based on the financial loss they would suffer if the insured person were to pass away. It is calculated using the following steps:

Step 1: Calculate the Insured's Current Income

This involves taking the insured's current after-tax earnings, which includes their after-tax salary as well as any employer contributions to retirement plans.

Step 2: Deduct Expenses, Premiums, and Income Tax Payments

From the after-tax earnings, subtract the percentage of income devoted to personal expenses, such as clothing, food, and individual transportation. Many financial planners use a general average of 75% for the family support ratio, assuming that the remaining 25% goes towards the breadwinner's personal expenses.

Step 3: Calculate the Number of Earning Years Left Before Retirement

Determine how many years the insured person is expected to work until retirement. This is the number of future years of income that need to be protected.

Step 4: Find the Discounting Factor Rate and Inflation Rate

Choose a conservative figure for the discount rate, such as the assumed rate of return on U.S. Treasury bills or notes. This is important because a life insurance company will leave the death benefit in an interest-bearing account. Also, take into account anticipated salary growth and inflation, which will impact future earnings.

Step 5: Determine the Present Value of the Required Income Stream After Including Inflation

Using the discount rate selected, calculate the present value of the expected income stream. This can be done using a formula or present value tables, which provide the present value of $1 at various rates of return for different numbers of years.

Example Calculation:

Suppose the insured person is 40 years old, earns $65,000 per year, and plans to retire at age 65. After following the above steps, it is determined that the family needs $48,500 per year to support itself if the insured person passes away. Assuming a 5% discount rate, the present value of this 40-year-old's future net salary over 25 years would be $683,556.

It is important to note that the Human Life Value calculation is a rough estimate and may not be a comprehensive assessment of a family's insurance needs. It is also important to consider other factors, such as the age, gender, occupation, and personal and financial information of the spouse and/or dependent children.

Fixed vs increasing income payouts

Life insurance is a contract between a policyholder and an insurance company that pays out a death benefit when the insured person passes away. There are several types of life insurance, including term and permanent plans.

When purchasing life insurance, you have options for how your policy pays out the death benefit. The two main types of payout are a lump sum and an income replacement. A lump sum is a one-time payment to the policy's beneficiaries, while an income replacement provides steady monthly tax-free payments to beneficiaries for a set number of years.

Fixed vs. Increasing Income Payouts

When it comes to income replacement payouts, there are two main options: fixed and increasing. With a fixed income payout, the beneficiary receives the same amount of money each month for the duration of the payout period. This can provide a sense of financial stability and make it easier for the beneficiary to budget and plan their expenses. However, the downside is that the purchasing power of the payout may decrease over time due to inflation.

On the other hand, with an increasing income payout, the beneficiary receives a higher amount of money each year, with the payout increasing at a set rate. This can help offset the effects of inflation and ensure that the beneficiary's standard of living does not decrease over time. However, this type of payout may be more complex to set up and may be more expensive in terms of premiums.

It's important to carefully consider the needs and circumstances of the beneficiary when deciding between a fixed or increasing income payout. For example, if the beneficiary is likely to invest the payout and generate a return, a fixed payout may be sufficient. On the other hand, if the beneficiary is expected to rely solely on the payout for their income, an increasing payout may be more appropriate.

Additionally, the length of the payout period is an important consideration. A longer payout period may provide more financial security for the beneficiary, but it also increases the risk of the insurance company defaulting on the payments.

In conclusion, both fixed and increasing income payouts have their own advantages and disadvantages. The best option depends on the specific needs and circumstances of the beneficiary, as well as the financial resources available to purchase the policy. It's always a good idea to consult with a financial advisor or insurance expert to determine the most suitable option for your situation.

Who should get a family income policy?

A family income policy is most useful if your loved ones would benefit from having the payout disbursed over a longer period of time. This type of policy is also ideal for those who want to replicate the income they would have earned and provided for their family if they were still alive.

A family income policy is a good option for those who want to make sure their beneficiaries receive the support they need when they need it the most. For example, if you have young children, you may want to ensure that your family has sufficient coverage while your children are still young and have a lot of expenses. However, you may need less coverage later in life when your children are grown up and you've saved for retirement and paid off most of your debts.

A family income policy is also a good option for those who think their loved ones would find a one-time lump-sum payment stressful to manage. Monthly benefit payments can be easier for beneficiaries to handle, especially if they would only need very little financial support in the final years of the policy.

Additionally, a family income policy can be beneficial if you are the sole earning member of your family, if you have dependents, or if you have loans or EMIs to pay. It can help replace your salary after retirement, provide additional income to support your dependents, and compensate for the money that gets eaten up by EMIs.

However, it's important to keep in mind that the biggest downside of a family income policy is that its value decreases over time. The longer you live, the less benefit your beneficiaries will receive. If you think you may need more coverage as you age, or if you want your beneficiaries to receive the full benefit amount regardless of when you die, then a standard term life insurance policy with a lump-sum death benefit payout may be a better option.

Frequently asked questions