Monday, May 14, 2007

Passive Income

During some point in every retirement plan someone comes up with the idea that passive income is king and it should be strive to the exclusion of everything else. The unfortunate thing about this is it often doesn't work for most retirement plans without some series drawbacks.

Passive income classically comes from the following main sources: investment income (interest, dividends and income trust distributions), real estate (a rental apartment or house), and a business in which you own a portion or completely (yet you don't handle the day to day operations of).

Generally I do believe passive income can be a significant portion of your retirement savings, but I don't typically suggest you plan your entire retirement around it. Why? It ties up a significant amount of capital to generate its cash flow which often results in people saving too much money for retirement. Yes if your truly paranoid about dying broke or wanting to pass along your entire savings to your children it can be useful. The other obvious exception to this guideline is if you have a low income and your all your investment income from dividends. In this case you have a significant tax advantage that makes it worth while to use.

To demonstrate what I'm getting at I'm going to use an example. Let's say I've got two people, A and B, who both want to retire 10 years early at 55 and need an income of $25,000/year. Person A wants to use passive income to pay for those years while person B isn't going to.

Person A is a adequate investor and manages to assemble a portfolio that pays a 5% yield to generate his $25,000/year (which is actually a fairly high amount of yield given the current dividend yield of most blue chip stocks). So total portfolio value should be $500,000 ($25,000 x 20).

Person B on the other hand is going to draw down his savings to cover those ten years. After that a combination of government benefits and pension income should cover the rest of his retirement. In his case he earns a 6% yield on his portfolio but his is also drawing down on the principle. So using this calculator he plays around and determines how much he needs to generate that savings by inputing a negative monthly savings rate of $2083.33 (or $25,000 per year). Overall $200,000 should provide 10 years of income and still have about $22,500 left over to cover an poor investment return years.

So overall person B can do the same thing as person A (ie: leave work ten years early) on $300,000 less in savings. Obviously more detailed analysis is required to account for taxes and changes to other parameters like yield, but generally I think more people are planning something like person B rather than person A.

10 comments:

MillionDollarJourney.com said...

I think the 2 different philosophies depends on whether the retiree wants to die broke or leave some money to their heirs.

Canadian Dream said...

FT,

Perhaps it me, but I think leaving money beyond real estate to your heirs is inherently stupid. If I live to my projected age of 85 my kid is likely going to be retired when the inheritance arrives, so really what is the point? I would rather help out the kids/grandkids when they are younger and can actually use the help.

Just my thoughts,
CD

MillionDollarJourney.com said...

Good points! Maybe i'm just being the devils advocate, but if someone has saved just enough to retire young, how are they supposed to help their children while they are young?

Canadian Dream said...

Why does 'help' always just have to be about giving someone money? Why can't it be a low interest loan for a house downpayment or providing some well timed childcare or building something that people really need? Helping someone else can often be low/no cost item to you.

CD

FinancialJungle.com said...

"...combination of government benefits and pension income should cover the rest of his retirement."

If person B is going to count on pension income, person A should do the same. That will reduce the $500k requirement for person A depending on how big the pension is.

Secondly, person A's yield should take care of inflation, and raising health care costs.

Canadian Capitalist said...

Maybe I am missing something but I am confused. How is B able to earn 6% on his portfolio while A earns 5%. BTW, both yield assumptions are far too high. I'd assume a yield of 2.5% (I am not talking average annual gains here) for a diversified portfolio today.

Also, I never understood the fixation over passive income either. To me, an asset's yield and its price are two sides of the same coin. Some dude won the Nobel memorial prize for figuring out that an asset's value is the total of all future dividend streams discounted to its present value.

Still, it is impossible to be precise about how much you need and it is better to build a significant cushion. If you die early, yes your heirs will inherit a sizable estate. If you die old, you won't die broke. Since you don't know when you are going to die and there is a significant chance that either you or your spouse will live into your nineties, its better to make conservative assumptions.

Thicken My Wallet said...

The advantage of passive income though is that it is tyically not a taxable event in that you don't have to sell anything to fund your life-style and trigger capital gains(not to mention the dividend tax credit if you are receiving dividend income).

If you are disposing of appreciating assets, you do get the double hit of reducing your estate and being taxed.

Canadian Dream said...

FJ,

Your correct both would receive the pension, but A would still require the same amount since A is using the cash flow model where he doesn't touch his principle amount. This results in more spending money when he turns 65 than B.

Actually in both cases yield would go up with inflation.

CC,

True the yields are high, but I picked them more as a random value than a specific return.

If you ran with 2.5% B would need around $250,000 and if you assumed the same yield for A he would need $1,000,000.

Overall I agree with you CC. I just tend to be less conservative in my calculations, but thanks for pointing out the overly high yield in the example.

TMW,

Taxes are really not different regardless in what you do. If you use the cash flow model (like A) you personally won't pay taxes, but your estate will (at least on the capital gains part). Beyond that you would have to assume asset classes and tax rates to come up with a complete picture. Which I felt was a bit over kill for the simple example I was presenting.

Good debate everyone,
CD

Adventures In Money Making said...

Ben Stein has a good book on this topic.
'yes you can retire' or something.

also check out these links
http://wealthbuildinglessons.com/2007/03/28/ben-steins-basic-rules-of-retirement/

http://wealthbuildinglessons.com/2007/03/19/what-are-canadian-royalty-trusts/

i love canroys for passive income. i intend to invest heavily in those through DRIPs and i should be set for retirement in 30 yrs!

http://www.winston-churchill-leadership.com said...

Passive income streams do not necessarily require significant monetary asset investment.

Musicians earn passive income from copyrighted work for 50 years. Authors too, provided their art sells can enjoy significant passive income.

Multi-level marketers can earn from their "down-line" with little work themselves once their network is established.

And my personal favorite chosen route: website info-preneurs can earn via affiliates schemes and ads on their content based websites once they are written.

Writing books or music arguably takes considerable talent to deliver financial success. MLMing and network-marketing can involve so much "work" as to be more like "active income" (i.e. a job). A website (or portfolio of websites)is low risk and easily achievable by any relatively motivated individual. My own retirement planning combines web-based income streams with property, offline business development and stocks.