The DEEM Method – The Best Way To Calculate Your Life Insurance Needs

Do you know how much life insurance you currently have? Is it enough to protect your loved ones if you were to unexpectedly die? Do you even know how much life insurance coverage you need? There are many methodologies to help you determine your life insurance need. We think the DEEM Formula^TM is the best option for you to use.

DEEM stands for Debt, Expenses, Education, and Mortgage. You set your needed life insurance coverage at a level that takes care of all these items. Doing so ensures that your loved ones don’t need to worry about expenses if you die. Nor do they have to worry about staying in a forever home on 1 income.

Therefore, we think DEEM Formula^TM is the best method for calculating a baseline life insurance coverage amount.

What Is Life Insurance?

Life insurance is a product that will pay out a death benefit to whoever you choose upon your death. You pay premiums to the insurance company and, if you policy is in good standing, they pay your beneficiary when you die.

Life insurance is one of the key components of the Protection pillar of the 5 Pillars of Personal Finance. It is also one of the least understood and most underutilized financial products. This is largely due to the complexity of most insurance products and the amount of effort required to get a policy.

Term insurance is a basic type of life insurance and typically a good fit for most people. Term insurance is one of the cheapest options as it only covers you for a set period of time. Alternatively, permanent insurance doesn’t expire, but it will typically cost 5 to 15 times more than term insurance.

Since your coverage needs tend to decrease as you get older, it is often recommended to set up a term insurance ladder that better matches your needs over time.

Additionally, since term insurance is cheap, you can opt for term and invest the leftover money into low-cost exchange traded funds (ETFs). This strategy is called “Buy Term & Invest the Difference” (BTID) and works well when you are young.

At the end of the day, the purpose of life insurance is to protect your loved ones. Whatever method you use, you should ensure that it results in adequate coverage. You don’t want your family to struggle if they lose your income.

But in order to find the optimal strategy for you, you first need to know how much life insurance coverage you need.

What are the 5 Methods to Calculate Life Insurance Needs

There are 5 general methods to calculate a starting life insurance amount. The 5 methods to calculate life insurance needs are:

1. Use a multiplier on income
2. DIME Formula
3. Human Life Value / Projected Future Income
4. Monthly premiums as a % of your income
5. DEEM Formula^TM / Future Expected Expense Coverage

Each of these methods has pros & cons and, depending on which you choose, may result in vastly different answers.

Using the DIME Method to Calculate Life Insurance Coverage

Our DEEM Formula^TM is a spin-off on the commonly recommended DIME method. DIME stands for Debt, Income, Mortgage, and Education. Under the DIME method you:

• Start with any outstanding debts (ie – student loans, auto loans, etc)
• Add in your outstanding mortgage
• Add in any college education costs you want to provide for your kids
• Calculate your future expected income you want covered by insurance
• Subtract any life insurance coverage you currently have, including any self-insurance
  • Even if you never purchased insurance, you may have some coverage. For example, if you work for a large corporation, there is typically ‘free’ group life insurance offered. Your company will pay out a death benefit if you die, usually around 1 year’s worth of your salary.

The resulting number is your starting life insurance coverage amount. For example, if you have $50k total in student & car loans, $250k mortgage, want to provide $50k in college funding for 2 kids, and make $100k a year as a 35 year old with 30 years to retirement, then:

• $50k in debt
• $250k in mortgage
• $100k in education for 2 kids at $50k each
• $3 million in income ($100k a year for 30 years)

You would get $3.5 million in life insurance coverage needs before adjusting for current insurance or savings. If you have no money saved and no other insurance, you should look at purchasing $3.5 million in coverage. This may seem like a lot, but it is an upper limit to fully protect your family under the DIME method.

Can it be improved on?

The DEEM Formula^TM

[Professor B.T. Effer Note – As far as we are aware, there is no references to a DEEM formula of life insurance needs. We are claiming a trademark on the method with this post. We view this as the optimal way to view life insurance too.]

You should think of insurance as a way to cover your dependents needs if you die. Therefore, you only need your entire income in your life insurance calculation if you are spending almost all your income. Which you shouldn’t be doing as you need to save & invest to grow wealth.

A much better method is the DEEM Formula^TM.

Under the Deem Fromula^TM, you follow the DIME calculation above, but replace income with your family’s expenses. Your cost of living should be less than your income amount.

An easy way to estimate your cost of living is to:

1. Start with your after-tax income
2. Subtract how much you save in retirement & investment accounts
3. Subtract payments on debts & mortgages
   • Since you are adding the balances of both debt & mortgage separate in the DEEM calculation, you want to exclude them from your cost-of-living expense. Otherwise you would be double counting them.

The resulting number is roughly what you are spending on lifestyle.

For example, if you make $100k a year, you pay 25% tax rate, you have $2,500 monthly mortgage payment & $500 monthly care loan payment. Additionally, you save 20% of take home pay for retirement. Then your cost of living would be:

1. $75k after-tax salary ($100,000 x (1 – 25%))
2. $6,250 monthly after-tax income
3. $3,250 monthly after-tax income after removing $3k of expenses ($2,500 mortgage & $500 debts)
4. $2,600 monthly cost of living ($3,250 x (1- 20%))

Another option is to use your expenses from your budget, it you have a budget. Which you should be budgeting. This will give a more accurate number to use.

DEEM Formula^TM Example

Using the same example as above for the DIME method we can recalculate using the DEEM method.

Reposting the example for ease of reading: “you have $50k in student & car loans, $250k mortgage, want to provide $50k in college funding for 2 kids, and make $100k a year as a 35 year old with 30 years to retirement”.

But lets assume you have a 20% tax rate and save around 20%. Additionally, another 20% of your budget goes to servicing your debt & mortgage payments. Using an approximation, that is 60% of your total income not being spent on your living expense. Of your $100,000 annual salary, only $40,000 is needed for your family to keep their current standard of living. Also, we will assume you want to provide coverage till your spouse reaches their expected age of 85, so 60 years.

• $50k in debt
• $250k in mortgage
• $100k in education for 2 kids at $50k each
• $2.4 million in income ($40k a year for 60 years)

You would get $2.9 million in life insurance coverage needs before adjusting for current insurance or savings. This is significantly less than the $3.5 million proposed under the DIME method. We also think this is a much better representation of your coverage needs.

Why The Other 4 Methods Result in Suboptimal Answers

We think that the 4 methods most commonly recommended all suffer from a fatal flaw. They focus on your INCOME instead of on the future EXPENSES your family is faced with. There are 2 main issues with using your income in these formulas:

1. Since you should be saving a high percent of your income, your family’s actual expenses are likely much lower than your income
2. Your income is taxed, but most life insurance is tax-advantaged. In many states, your entire death benefit is tax-free.

Using the income multiplier method as an example, it is commonly recommended to use 10x your annual income as a starting coverage amount. If you have 2 people who both make $100k a year, you would have $1 million in coverage using the recommendation. However, if person A lives in a low cost state and only spends $30k a year while person B lives in an expensive state and needs $80k a year, their resulting coverage needs would be very different.

Adjustments To Make To The DEEM Formula^TM

There is room to make adjustments to further refine the DEEM Formula^TM (or any of the above methods).

• Inflation: Inflation increases the costs of goods and services you purchase. To reflect inflation, you would adjust your insurance higher as both income and expenses would be increasing in the future.
• Lifestyle Increases: Different than inflation, lifestyle increases is due to life getting more expensive. A 5 yr old may have less costs than a 15 yr old which would lead to a higher insurance amount required
• Discounting: Discounting is like a mirror of inflation. Whereas inflation says that your $30k cost of living is going to grow 2% a year and be $50k a year at retirement. Discounting says if you need to cover a $50k expense in the future, you don’t need all $50k today. You could put money today into an asset and grow it to $50k. Therefore, discounting decreases the money you need to cover all your expenses.
• Post-Retirement Expenses: Many people see expenses come down for part of retirement. You may imagine it is all vacations and country clubs. But for many people, with no commute, work, or networking, they see a decrease in post-retirement expenses.
• End of life care: One of the biggest costs is end of life care. Whether it is a nursing home, a live in aid, or extended hospital stay, the last year of life can be your most expensive. If you are trying to cover your spouse’s full expenses, you may want to consider a high final year.
• One Less Life: Are you a big spender? than your family cost may sign decrease if you die, adjust for 1 less person spending money. Even if you are equal spenders, if you are not there, most daily expenses are cut in half.

The Final Word – DEEM Formula^TM For Life Insurance Coverage

Life insurance is important to protect the needs of your loved ones after you pass. There are many potential methods to calculate your life insurance coverage needs. However, we think a tweak to the DIME formula is the best representation of actual needs.

We walked through the Debt, Expenses, Education, & Mortgage (DEEM) methodology. And provided a list of modifications you could make to further refine the calculation.

Ultimately, your insurance decision is specific to your your unique needs. You should ensure you have adequate coverage to protect your loved ones if you unexpectedly die. The DEEM Formula^TM is a great place to start