The capital liquidation approach is one of two methods of calculating your family’s life insurance needs under the family needs approach. It is not an independent approach. Rather, it is one of two ways to determine the lump sum of insurance proceeds the surviving spouse needs to receive and invest to provide for ongoing family income needs. Under this approach, you estimate the necessary lump sum assuming that you will be liquidating all the proceeds over the surviving spouse’s remaining life expectancy. The idea is that the proceeds, or capital, will be used up either at or slightly after the end of the surviving spouse’s life expectancy. In other words, your family’s life insurance proceeds should last just through the four ongoing income periods: readjustment, dependency, blackout, and retirement. This way, you reduce the amount of life insurance you need to purchase while covering for your family’s needs under the most likely scenario: the surviving spouse not living significantly beyond his or her life expectancy.
Under the alternative capital retention approach, you purchase more life insurance to retain all of the principal for supporting the family indefinitely into the future. As a result, you are better positioned for either of the following situations:
- Your surviving spouse outliving predicted life expectancy
- Your wanting the heirs to inherit some of the proceeds after the surviving spouse dies
You have to pay more up front in premiums, however. For example, you estimate an insurance need of $800,000 for the 30 years of your surviving spouse’s life expectancy using the family needs approach. If you use the capital liquidation approach, you can settle for somewhat smaller insurance proceeds because you won’t depend entirely on the investment returns for the $800,000 need. Some or all of the proceeds themselves–the capital–will supplement investment returns to provide the $800,000 needed by your family. If, on the other hand, you use the capital retention approach, you will want proceeds that, if invested, will yield $800,000 during this period entirely from the investment returns.
Why Choose the Capital Liquidation Approach?
You should focus on capital liquidation when using the family needs approach if you wish to spend less on life insurance to cover your family’s ongoing income needs. At the same time, you should be comfortable with using up your family’s available life insurance proceeds over the course of the surviving spouse’s remaining life expectancy. Of the two approaches, capital liquidation arguably is the riskier approach. You are gambling that the surviving spouse won’t substantially outlive his or her life expectancy. If the spouse does, the family won’t have any insurance proceeds left to liquidate in order to provide for the spouse’s continuing income needs.
Strengths
Less Spent on Life Insurance
If you focus on capital liquidation when using the family needs approach, you can spend less on life insurance than if you were concerned with preserving some or all of the insurance proceeds into the indefinite future.
Tradeoffs
Risk That the Surviving Spouse Will Outlive the Insurance Proceeds
Under this approach, the insurance proceeds will be liquidated over the surviving spouse’s remaining life expectancy or perhaps slightly longer. If the surviving spouse significantly outlives his or her life expectancy, your family may have no proceeds left to generate needed income. (Interestingly, in the past several years, actuarial experts (actuaries) have projected much higher life expectancies for most Americans, barring war, epidemic, or natural disaster. Most insurance companies have yet to update their actuarial tables to reflect the longer average life span. If these projections hold true, then the capital liquidation approach will be much more risky.)
May Not Be Able to Pass the Capital to Heirs
If the surviving spouse lives at least as long as his or her life expectancy, the heirs won’t be able to inherit any of the capital represented by the insurance proceeds, because the proceeds will have been exhausted. If the surviving spouse dies before the end of his or her life expectancy, a portion of the proceeds may have been used up and may be no longer available to the heirs.
How to Use the Capital Liquidation Approach
Generally speaking, the family needs approach requires you to make the following calculations in order to estimate life insurance needs:
- Immediate needs at death
- Ongoing family income needs
- Expected other income sources
The following equation yields an estimate of the insurance you need:
Immediate needs at death + Ongoing family income needs – Expected other income sources = Family needs
Your choice of the capital liquidation approach versus the capital retention approach affects your figures for the insurance amount necessary to cover the ongoing family income needs. If you choose capital liquidation as opposed to capital retention, you won’t require as much insurance proceeds to invest in order to cover the ongoing family income needs.
If you have questions or need assistance, contact the Experts at Henssler Financial: experts@henssler.com or 770-429-9166.