Posted by Tim Stobbs on May 14, 2007
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.