Life Insurance with Frito
The Madigans' First Child.
Well, that didn’t take long. Zumba class after a morning snorkeling lit a spark that ignited an unexpected payoff. Don’t know the gender, but John and Kelsey Madigan are expecting their first child early next year. Amongst themselves, they refer to their future family member as “Frito,” after their best friends, Adoncia and Frito Delfin, who own Frito’s Bait & Tackle in Hialeah. Never would have met the Delfins sitting in Youngstown. Frito Madigan. Irish parents. Cuban namesakes. An American narrative. As my friend Jim might say: “you can hear Kate Smith’s voice singing in the background.”
There is a financial story and it turns to life insurance with children in this follow-up post. Subscribers met the Madigans in a prior post that illustrated how to determine whether life insurance need exists in a household. Two income, no children couples may have a life insurance need depending on how the living standard of the survivor changes by the premature death of the decedent. That is the approach of Personal Finance Economics. But how impactful is a child such as Frito on the adults’ living standard? Care is required. A bit like reaching into the refrigerator at the summer lakehouse sleepy-eyed for the breakfast yogurt and retrieving Dad’s Styrofoam container of bloodworms. Would John and Kelsey’s pre-child life insurance prescription change post-child? Anecdotally, most think it would. Changes in family makeup matter because economic dependencies shift. But, it is more complicated than assuming life insurance is needed once children arrive.
The Base Case
We need to first re-establish the Madigans’ optimal living standard as a household of two.1 Some background and a financial update. The Madigans’ two-income household has some good financial news: John has just learned he is receiving a raise to $90,000 per year, while Kelsey earns $45,000 and intends to work after the birth of Frito which is expected early next year. John and Kelsey, both age 40 today, intend to work up to age 70 and have forecast max lives to age 95. Beyond earnings, the Madigans’ own $30,000 in bank checking and savings assets, and have regular IRAs. John has $19,000 in his IRA, Kelsey $10,000. They plan on each contributing $1,000 per year in real dollars to help fund their lengthy retirements. 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. John’s raise has changed their financial condition. Higher income, more income taxes to pay, and a likely tweak-up in his social security retirement benefits.2 How does their updated financial condition adjust their living standard and life insurance needs?
Pre-Frito, the base case optimal level of discretionary spending in the current year after the Madigans’ housing costs, retirement contributions, and taxes is $69,886, displayed in the table below. Nearly $70,000 is the ideal spend in the current year beyond the budgeted housing, retirement contributions, and taxes listed. This targeted spending amount implies a living standard for John and Kelsey to be $43,679 each, because of the economic benefits of shared living. Two individuals’ living together live more cheaply than apart.
The life insurance need today on John and Kelsey’s lives are $1.37 million and $138,000, respectively, and decline over time, reflected in the chart above. This is typical for most households. The need for any life insurance on John’s life expires around his age 70. Kate around age 55.
Life with Frito
The base case life insurance solution is set. In planning for life with Frito or any dependent, we state the obvious: there will be a financial effect on the household. Children consume too, and have other attached costs. In our modeling, to determine the optimal amount of discretionary spending, we assume children consume at the rate of 70% of an adult in the same household. In addition, for most families, income doesn’t suddenly jump when the children arrive; the same level of income supports new expenses wedged into existing expenses. This has the expected effect of lowering the optimal, annual amount of spending that can be undertaken to support the household and, in turn, the impact on the adults’ living standard.
Panel B below shows the level of current year optimal spending, shone with the light of Frito’s forthcoming birth next year. In this scenario, the Madigans’ preferences were two-fold,
Kelsey intends to continue to work after Frito’s birth
Frito is out the door at age 19
Obviously, it should be lower this year in anticipation of lifestyle changes once Frito is born, because the current is pulled out of the optimally-derived lifetime financial plan. The impact, simply because of the forthcoming presence of Frito, is a lowering of the per adult living standard by about 6.5%. Not displayed here but in the full financial plan, the effect of one child on the totality of John and Kelsey’s lifetime living standard is to lower it, but the result is inconsequential.
Since this is considering only another mouth to feed, we add another Madigan preference.
Explicitly budget for Frito’s child care expenses
Panel C reports current year optimal spending assuming that from the time of Frito’s birth and for ten (10) additional years, that real annual child care costs are $10,000. These costs drop the optimal household spending for all other non-listed expenses this year, even a year in which there is no child, by about $5,600, and the per adult living standard by about 15%, relative to the Madigans’ no-child days, Panel A.
Life Insurance with Frito
The changes to the living standard with Frito impact the preferred levels of life insurance. The life insurance choice that best supports the economics of the Madigans’ household with Frito centers on restoring the survivor to their pre-loss living standard with Frito. Lines in the chart below can be compared to the “w/o Frito” life insurance results in the chart above. Life with Frito entails slightly less life insurance for the John today and an amount near $0 on Kelsey’s life. How can that be? It is part the Madigans’ financial position, and part economic logic. With all the joy that Frito is expected to bring, it is undeniable that Frito’s presence will negatively change John and Kelsey’s living standard while everybody is alive. It is this lower living standard that becomes the target for determining life insurance need when both adults and children are present in the household.
Take John as the one who dies prematurely. If John dies without life insurance, Kelsey’s living standard takes a huge financial hit. How can she achieve the standard to which she has grown accustom on only $45k in pre-tax income with a mortgage, child with child care expenses, etc.? The level of benefits that should be provided will be focused on restoring Kelsey to her living standard as if John were alive. Restoration is large with Frito in the picture, whether child care expenses are added into the mix or not.
Now flip it. If Kelsey dies prematurely and John had been living life under a lower living standard because of the presence of Frito, his relative high income plus Kelsey’s economic absence, will permit him to easily maintain the living standard to which he has grown accustom. It doesn’t mean that Frito no longer has an impact. Frito does have an impact on John’s lifetime living standard. Under present assumptions, the loss of Kelsey and the magnitude of her lost income combined with the freed-up spending for John, implies a very low life insurance need on Kelsey’s life.
Life with Frito through College
Maybe, someday, Frito will get into a buy-sell agreement with his namesakes and build a Bait & Tackle empire in south Florida. College could help and the Madigans’ want a peek at their financial plan and life insurance needs under an additional scenario.
The Madigans’ support Frito to age 22 including 4 years of college
In thinking about this last scenario, the Madigans’ undertook research on educational costs. Annual private university costs (tuition, fees, room & board) ballpark in the $75k/year range (yes, big gulp), so they intend to target about a third of that, $25k per year in today’s dollars, for the four years of Frito’s prospective college education. The chart below focuses only on the recommended amount of life insurance on John and Kelsey’s life under two scenarios, a) Frito is supported to age 19, and b) Frito is supported to age 22 with some additional support for college expenses. Arrows point to life insurance need under the longer dependency period when a portion of anticipated future college expenses are placed with the family budget. Still, it is evident life insurance needs are not too different.
Why is there little life insurance change when the Madigans’ consider spending roughly $100,000 to support Frito during college? There is an effect, but through the prime lens of a the Madigans’ long lifetime, not substantial. After Frito graduates, his parents will be 62 with a few years of earnings up until age 70, then consumption needs are handled by indexed social security retirement benefits and IRA withdrawals to age 95. If Frito goes into the fishing business and it turns belly-up, then he may need additional help. Otherwise, John and Kelsey are looking at 55-years of living from today with the back 33 of them without a dependent. As empty nester’s know, once the kids move out the household gets a raise.
All these other important factors such as investment returns on retirement funds and cash assets, taxes under current tax law, and social security benefits under current law for John and Kelsey’s incomes are included in the analysis. The financial plan can be found on my site, under the Substack tab.