Highest Yield, No Risk, and a 5% Income Need
Denise, 63, has $600,000 in a taxable account and needs $30,000 a year of spendable income. Her marginal bracket is 32% federal, and she lives in a state that does not tax in-state municipals. Her representative presents three options: (1) a 10-year callable step-up note issued by a single A-rated insurer, paying 4.25% for years 1-3 and 5.25% thereafter, callable at par beginning in year 4; (2) a diversified ladder of A-rated in-state municipal bonds yielding 3.90%; (3) a non-qualified deferred variable annuity with a 1.10% mortality and expense charge and a seven-year surrender schedule. Denise says she 'just wants the highest yield and no chance of losing money.'
1. Which option produces the most after-tax spendable income today? Show the tax-equivalent yield calculation.
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Compare on an after-tax basis:
- Muni: 3.90% is already after-tax. Tax-equivalent yield = 3.90% / (1 - 0.32) = 6.09%. Spendable income on $600,000 = $23,400.
- Step-up note, year 1: 4.25% x (1 - 0.32) = 2.89% after tax; spendable = $17,340. Even in year 4 the 5.25% coupon nets only 3.57%, or $21,420.
- VA: no stated yield, and the 1.10% M&E charge is a direct drag inside the contract.
The muni wins on spendable income despite the lower headline coupon, which is exactly the trap Denise's 'highest yield' framing sets up.
2. Denise needs $30,000, which is 5.0% of $600,000. What does that tell you, and what are the two risks she is most underestimating?
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The income target is not achievable from any of these options without invading principal. $30,000 / $600,000 = 5.0%, above the 3.90% muni yield and above the note's after-tax return. Any presentation that implies otherwise is misleading.
Risks she is underestimating:
- In the step-up note: call risk plus credit and liquidity risk. The issuer calls at par in year 4 precisely when rates have fallen, forcing reinvestment at a lower yield - she captures the 5.25% only if rates rise against her. It is also a single-issuer obligation in a thinly traded security.
- In the annuity: surrender/illiquidity risk and cost drag. A seven-year schedule means most of her $600,000 is locked up with penalties if her needs change, while the 1.10% M&E charge compounds against her annually. Her age means no 10% federal penalty applies, but the state penalty and surrender charge still do.
3. How should the representative respond to 'no chance of losing money,' and what recommendation is defensible?
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Do not affirm the premise - a single-A callable note, a municipal ladder, and a variable annuity all carry loss potential (credit, interest-rate, and market/surrender risk respectively). Correct the expectation in writing and document it.
A defensible path:
- Reframe the objective as $30,000 of cash flow with a defined tolerance for principal fluctuation, and ask how much of the $600,000 she is willing to draw down over 20-plus years.
- Solve with a combination: the muni ladder for the tax-efficient core plus a defined slice of principal or a short-duration bond sleeve to bridge the shortfall, rather than chasing yield in a single-issuer structured note.
- Note that some income may be tax-free at the federal level but still count in her Social Security provisional income calculation - muni interest is added back for that purpose, so the 6.09% TEY overstates the benefit if she is receiving Social Security.
If she insists on the step-up note after a full explanation, that is her call - but a suitability note recording the call risk and concentration is mandatory.