Do the Madigans' Need Life Insurance?
The Economics of the Decision.
John and Kelsey Madigan live in Miami and love the tropical lifestyle. Snorkeling, tennis, and the occasional trip to the Biscayne National Park are shared experiences that give them so much happiness they often wonder why it took them so long to move from Youngstown in the 2010s. After all, the Stoops brothers left the area for football coaching fame. Maybe it was their turn for a better life.
One day in the midst of an Ohio winter Kelsey told John, “let’s go build a new life somewhere. I want a fresh start.” They moved in January 2014 to south Florida. Miami was their choice because it is warm, sunny, and the Madigans’ felt “our money will go farther.’’ John had management experience and he took the lead in finding a job. Today, John is the general manager of a popular seafood restaurant and Kelsey is a librarian in the Miami-Dade public library system.
The Madigans’ received a call from a life insurance agent who was referred to them by friend from their Zumba class, another athletic endeavor that keeps their sparks’ lit. John and Kelsey never thought too much about life insurance, although they read the News in the Wall Street Journal that reported recently about an uptick in life insurance product sales among younger adults attributed to a pandemic response. Nightly reports of death and dying will do that.
Because of the agent’s initiative, the financial planning question du jour for the Madigans’ became whether life insurance should be front and center in their financial life. “Why have it, we don’t have kids.” “Will the agent be pushy.” “We can find 500 other things to spend money on, rather than life insurance premiums.” Personal Finance Economics speaks precisely to their concerns. Indeed, they have relevant generalities common to many couples: The Madigans’ are without children today, don’t plan on having a child in the future, but otherwise live a lifestyle afforded by a dual income and the economics of shared living.
A Very Short History Lesson
Life insurance products and the institutions that offer them have been around for a very long-time, beginning about 275 years ago and before the founding of the U.S. Silicon Valley wordsmiths so adept at single word, brand names might not like the name of the first life insurer, “The Corporation for Relief of Poor and Distressed Presbyterian Ministers and of the Poor and Distressed Widows and Children of Presbyterian Ministers.”1 Put that in a URL. Wouldn’t be much space left on the title screen of the mobile app. Today’s well recognized brand names are moving toward their 200th years. New York Life (1845), Mass Mutual (1851), MetLife (1868), and the list goes on. Fewer words. But, talk about a mature industry!
Why do these institutions exist? Better to ask why households’ demand life insurance which has been a question asked by academicians for years and Leibenberg, Carson, and Dumm (2012) have interesting empirical findings based the Survey of Consumer Finances for a range of years from the 1980s. The researchers found life insurance demand increases among new parents and households with new jobs, and decreases through cancellation of existing whole life policies among households who experience unemployment, and a reduction in existing term life policies among the newly widowed or separated.2 Affordability and rational motivation help to understand demand. Price needs to be reasonable (which it is for term life insurance) and demand is linked to need. The payoff from life insurance is a death benefit payable to a beneficiary, not the insured. Widows, widowers, and singles don’t need to buy life insurance, but those partnered, married, or with children and dependents may.
The Link to Human Capital
Who depends on your ability to produce an income? You do, of course, but we are considering the risk of you dying too soon. After that, who suffers economically? A spouse, partner, children, some other dependent family member, a charitable organization that has come to rely on your generosity? If the answer is “none of those apply to me,” then you don’t have a need for life insurance or the life insurance products that can be inaccurately promoted as investment vehicles.
Life insurance is intended to handle the risk of premature death. Nothing more, nothing less. Some life insurers, unfortunately, paint their products with speculative risk, tying future premium costs to investment performance. If you are confused that a conversation about life insurance turns to a conversation with a life insurance agent about how a life insurance product can be an investment then you should be skeptical. If you ever start talking to a sales representative or advisor about the need for life insurance, and the conversation turns to a product discussion about asset classes, cash values, and guaranteed rates of return wonder, “what just happened?” This isn’t uncommon. Masking a product intended to handle a pure risk and obscuring it with speculative risk is a company strategy to help sell a simple product that is otherwise a tough sell. After all, a sale requires a conversation about futures without loved ones.
Pause on the curve ball and let your confusion be a lock on your wallet. Find another agent. One that takes you through a life insurance needs analysis based on the principles of Personal Finance Economics. The Madigans’ example illustrates the proper approach.
The Madigans’ Life Insurance Question
The Madigans’ live together. The economics of shared living is an important consideration when determining life insurance need. The essence is that two adults living together can live more cheaply than two adults living apart because many non-discretionary household expenses are not additive. Two adults living together don’t double the mortgage, the light bill, or the streaming subscription. The result is that a higher living standard is conveyed to two, four, or six, adults living together, relative to the same count living apart. Moreover, the per adult household living standard may heavily depend on the higher income earner. The lower earning spouse in a marriage lives at a higher living standard than would otherwise be attainable alone. Throw non-income producing children into the mix and living standards of all household members adjust to new levels based on the prospective earnings of the providers. A substantial expected living standard forsaken because of the premature death of a breadwinner signals a life insurance need. Back to the beach.
The Madigans’ have a two-income household. Their lifestyle is built around a household income of $130,000. John earns $85,000 per year and Kelsey earns $45,000 per year, and both expect to work up to age 70. Family health histories and their personal health histories suggest planning to a max age of 95. Because John and Kelsey are 40-years old, they have an implied work life of 30 years to fund living for more than 50 years. Inflation indexed social security retirement benefits will be important to their financial future. Their long-run living standard will be higher because of their choice to not have children, but it is likely savings will be prescribed due to the balance of work years and living years.
Beyond earnings, the Madigans’ own assets and have minor debts. The Madigans’ home is valued at $800,000 which they purchased eight years ago for $340,000. Their mortgage runs about $1,305 per month and annual property taxes and housing maintenance total $10,000. Both have a modest amount of money in regular individual retirement accounts (IRAs) and $30,000 in a joint bank checking and bank savings accounts. Unfortunately, neither has an employer-sponsored retirement plan such as a 401(k). Both intend to contribute $1,000 per year to their IRAs and adjust this contribution for salary increases.
The Madigans’ optimal amount of spending for the current year after their housing costs, retirement contributions, and taxes is $67,586. How did I know that? Built their baseline financial plan with the optimization techniques applied to prior posts. Their optimal, household spending after taxes and some key fixed spending items is the “optimal discretionary spending” line in the table below.
Note there is an amount budgeted for life insurance premiums because during modeling it was found that life insurance should be purchased. More on that in a moment. What about the living standard per adult? Economists approximate that two adults living together can live as cheaply as 1.6 adults. John and Kelsey have total, optimal discretionary spending for the current year of $67,586, but that doesn’t mean they each have a living standard of half that amount, $35,793. Because they live together, the annual living standard for each is higher, approximately $42,241. This number is key for any life insurance consideration because it is the living standard to which each has grown accustom.
Life insurance is needed to maintain the optimal living standard of the survivor(s). If Kelsey dies, then it appears John’s higher salary ($85k) may be able to help John attain this living standard without Kelsey. If John dies, then there is no way Kelsey’s living standard based on her income alone ($45k) could reach that number. Mortality risk odds are slightly in Kelsey’s favor, but the outcome of John’s mortality could be severe to her future living standard. John benefits financially from Kelsey’s income and it is likely his living standard would be disrupted, although less so, should Kelsey die during her working years. In general, the proper amount of life insurance policy death benefit can be viewed as an asset injection to a beneficiary to supplement their other assets and income.
Optimal Life insurance Amounts for John and Kelsey
How much life insurance is needed in the Madigans’ household? The prescribed economic solution is drawn in the chart below. If John were to die this year, then Kelsey would need $1.291 million of life insurance death benefits to maintain her per adult living standard for the rest of her life. This cash infusion, in large part, is the replacement of the impact of John’s human life value on Kelsey’s living standard. By contrast, if Kelsey were to die this year, John needs about $191k of life insurance death benefits to keep him at the same living standard as if Kelsey were alive and working. If Kelsey maintains life for another 20 years, there will no longer be a need for John to own life insurance on her life. John will need to maintain life insurance until age 69 under current assumptions but Kelsey economic happiness on the life insurance dimension only requires John to maintain less than $500k of coverage once he reaches age 61.
How Investments Change the Need for Life Insurance
What if the Madigans’ had been aggressive savers and to date had put away $1 million into a brokerage account, rather than have only $30,000 of bank assets? How would that alter life insurance need?
The first-step is to recognize that their living standard while both alive is higher because of the extra cash. I turned the modeling crank and found their optimal level of household discretionary spending for the current year rose to $83,304, conveying an optimal living standard for each of $52,065. Put in the context of their overall life span, the additional million dollars increased their annual living standard in the first-year by 23%. This becomes the new target for determining life insurance need.
As can be seen in the chart below, the only life insurance to be purchased will be on John’s life for Kelsey’s benefit should John die prematurely. If Kelsey dies prematurely, John’s normal earning capacity plus his large cash reserves make Kelsey’s lost income to John inconsequential to his standard of living. But, the opposite is not true. The magnitude of Kelsey’s $45k income plus annual returns on the $1 million of assets cannot get her to the living standard when John is alive and working. Initially, John’s life should be insured for $954k then it gradually declines. By age 60, Kelsey needs only $300k of life insurance on John’s life and by age 68 the life insurance need on John’s life vanishes.
Periodic Life Insurance Needs Analysis
It is important to review life insurance need periodically. Swings in salaries, revaluation of assets, and a changing family makeup will alter the optimal living standard while alive. These changes will drift into the life insurance question.
Who knows about the Madigans? The effect of an afternoon Zumba class after a morning of snorkeling may change their calculus.