John, 38, makes $85,000 per year. He has a 37 year old wife, Nancy, and a daughter who just turned 7. John’s share of the family’s consumption is 18%, and he pays an average tax rate of 24%. He plans to work another 27 years and expects salary increases equal to inflation, which he expects to be 3% annually. He expects to earn an 6.5% nominal rate of return on his investments.
1. Use the Human Life Value (HLV) method to calculate John’s appropriate amount of life insurance coverage.
2. In the event of John’s death, Social Security will contribute $20,000 per year to his family while his daughter is 16 or younger (10 years) and $10,000 per year while his daughter is 17 & 18 (2 years). The family will need total income equal to the Family’s Share of Earnings (FSE) until the empty nest period begins, at which point the family’s annual funding needs will decrease by $12,000. Nancy will require $41,000 in annual total income during retirement beginning at age 66. She will receive $15,000 in annual retirement benefits from Social Security and expects to live until age 85 (20 years of retirement). Finally, the family has lump sum funding needs of $112,500 and $35,000 in liquid assets.
Assume that John’s daughter’s college education is already being funded from the FSE and therefore does not need to be explicitly considered in the analysis.
Assume all monetary figures above are quoted in real terms, i.e. today’s dollars. Calculate the amount of life insurance coverage John needs according to the Financial Needs Method. Show your work (calculator inputs are fine). This problem is slightly simplified compared to the example in the Powerpoint. I am not specifying a readjustment period, and more importantly I am not asking you to assume that the cash flows need to come at the beginning of each period (BGN mode not necessary). This will make the problem much easier to do on your financial calculator. See the DCF powerpoint on Canvas for tutorials on how to calculate NPV using your BAII+ (slide 24) or your TI-84 (slide 25). For each year, take the family’s total income need and subtract the amount that Social Security will contribute. The leftover amount is what needs to be funded by the life insurance policy. Set the amount needed while the daughter is 16 or younger as C01, set F01=10, and so on – C02 and F02 for when the daughter is 17 & 18, C03 and F03 for the empty nest period (19 years), and C04 and F04 for the wife’s retirement. If you don’t have a financial calculator, you’ll need to plot the family’s future annual funding needs in Excel. Finally, calculate the NPV using the real interest rate, add the lump sum funding needed, and subtract the family’s liquid assets to calculate the coverage needed.
3. Use the Capitalization of Earning method to determine John’s appropriate life insurance coverage (note: use FSE and the real interest rate).