(This article updates a piece I wrote for Forbes in 2010.)
Economics can't say what's fair, but it can help with divorce settlements by showing who is really getting what and how to make the best out of a bad situation.
Take Frank and Stacy Loveless. Frank is 45; Stacy is 38. He's a dentist; she's a dietitian. They live in Saint Louis with their two girls, ages 7 and 3. The couple met in Frank's dentist chair a decade ago.
Stacy asked him out and, boy, what a wedding and what a great marriage until, well, things changed. Their main goal now is settling their affairs without declaring war or wasting their assets on an extended legal battle.
Not easy. Stacy has never been great with numbers. But she's nobody's lunch meat and isn't sure Frank's offer is all that generous. Frank is the big earner, netting $150K a year. Stacy earns $30K. The dental practice, were Frank to sell, is worth $300K. The couple has $700K in regular assets, which they invest conservatively and expect to earn 3% after inflation. They also own a $300K house with a $200K mortgage, which they are paying off in 15 years. Frank has $300K in his 401(k).
Frank is offering Stacy the house and half their regular assets. He'd keep his practice, his 401(k) and live in a rental at $2,000 per month. He'd also pay $15K per year per child in child support (not adjusted for inflation), pay $40,000 (adjusted for inflation) for college for four years for each child, but nothing in alimony. Frank claims this is more than fair.
Let's listen to their exchange.
"Look Stacy, I'm giving you half our assets and the house."
"Whoa big fella. Aren't you forgetting the mortgage?"
"Well, OK, but there's only 15 years left, and the interest is deductible."
"I may not have enough deductions to itemize."
"Well, all the money in my 401(k) is taxable on withdrawal."
"Yes, Frank, but you're making five times my salary."
"Right, and paying 10 times your taxes."
"You can sell your practice." "Not until I stop working."
"I'm a lot younger. My money has to last longer."
"You have more years to earn."
"I also have more years to feed, clothe and house myself. And, by the way, you're paying $2,000 a month to rent an identical house, while I have all the housing expenses."
"You can sell the house when you retire and rent the same type of place."
"Your Social Security is going to be much higher than mine."
"Well, dear, let's not forget Social Security divorcée benefits."
"My own retirement benefit will wipe out my divorcée benefits."
"What do you know about Social Security?"
"A lot more than you, apparently."
"You'll get my check when I die as a widow's benefit. Trust me, this is a great offer."
"Don't patronize me."
"Stop calling me cheap."
"See you in court!"
Is Frank being generous? Or is Frank being a cheap (fill in the blank)? More precisely, is Frank setting himself up to have a much higher living standard than Stacy?
Analyze My Divorce Settlement, which my company markets for $99, can readily calculate each party's living standard based on the proposed deal taking all the demographic, child support, earnings, asset, alimony, housing, tax and Social Security benefit factors into account. You just run the program for Frank and Stacy as separate single individuals and compare their living standards under whatever divorce settlement is being contemplated.
Turns out that Stacy is right. Frank's living standard (discretionary spending) is $43,326 a year, measured in today's dollars. He can spend this amount annually, straight through age 100 (his maximum age of life and proper planning horizon) after he has covered his taxes, child support, college tuition and rent.
Stacy's living standard is only $18,978. This is what she gets to spend on herself through age 100 after providing the kids with the same living standard as she enjoys and after covering her taxes and housing expenses.
Of course a lot depends on Frank being able to work until 65. If his aching back ends his career at 60, his sustainable living standard falls to $34,218. But this is still almost 80% higher than Stacy's.
Once Stacy generates these figures, shows Frank the software, and convinces him the results are right, she starts lobbying for $25,000 per year in alimony (not adjusted for inflation) through Frank's age 65 - the retirement age assumption Stacy continues to make. This only lowers Frank's living standard to $38,266 because it's time-limited and because Frank can exclude his alimony payments from his taxable income. But the alimony is, again, time-limited and taxable, so it raises Stacy's living standard to only $23,463.
Stacy's still 39% behind the eight ball, but this is the most she can get from Frank without going to court and facing a judge who may split the assets 50-50 and award zero alimony, or alimony that only lasts for a transitional period.
After reaching this agreement, Frank and Stacy start helping each other tweak their plans and find they can raise both of their living standards by making smarter decisions regarding Social Security and saving via retirement accounts. As a result, Frank is thinking of upping his alimony payment. And the more he thinks about it, the more he realizes that Stacy should have a living standard that's closer to the one he'll enjoy. Frank also realizes that he barely escaped waging a terribly expensive and unjust legal fight based on his mistaken assessment of what was really fair.
What are the takeaways from Frank and Stacy's ultimately amicable divorce? First, our finances are incredibly complex - so complex that no one can possibly know (even the highest-priced divorced attorney) without the right tool, what's a fair divorce settlement. Second, economics is now in a position to help people understand what is and is not a fair divorce settlement. And third, divorce can be a win-win proposition.
Note of disclosure: I will often, in my columns, reference my company's (Financial software, strategies, and insights | Economic Security Planning, Inc.) software. I do so because it's unique, inexpensive and can help people. It's also the only economics-based financial planning software on the market. I started the company in 1993, so we're now 25 years old. My sister and oldest son work for the company, but I personally don't receive a penny of income and never have from the company. On the contrary, the company owes me money! My goal is to employ a fabulous team of people who care about helping others and to deliver my profession's financial guidance to the public in highly accessible forms at lowest possible cost.