July 19, 2024
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July 19, 2024
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Why You Should Take an Interest in Passive Income

From a financial perspective, the heart of retirement planning is providing passive income. Passive income is income that is not derived from one’s labor. Instead of working to make a living, in retirement an individual’s accumulated assets become the source of income.

In the personal financial services arena, a default source of passive income for many retirees is derived from interest-bearing financial instruments. These products deliver a regular stream of interest payments at pre-determined rates, and many include guarantees. Savings accounts, Certificates of Deposit and bonds are three common types of interest-bearing financial options. Regular, secure payments offer retirees a measure of financial certainty, which is an important consideration when passive income must be used to meet essential material needs.

A conventional retirement model involves an accumulation phase and a distribution phase. These retirement models are designed for individuals whose financial plans are fairly straightforward: a portion of current earnings from regular employment will be set aside on a regular basis in order to provide future passive income.

Because of the underlying investments, the interest earned on these income-producing instruments has a strong correlation to market rates for lending and borrowing. As interest rates have declined and remained depressed, the returns from these products have diminished, in some cases significantly. This scenario challenges many retirement strategies, because lower returns mean less income; retirees are left with the undesirable option of reducing their standard of living or consuming principal in order to maintain current income levels. Or they must consider income-generating alternatives, some of which may not be offered by financial institutions.

What are some examples of other passive income instruments?

Dividends: A dividend is a sum of money paid regularly by a company to its shareholders out of its profits. Many companies have a long history of regular dividend payments to their shareholders. But dividends are not guaranteed; some companies declare no dividends, either because there are no profits, or because the company’s management decides to reinvest profits instead of distributing them.

Owners of participating life insurance policies may also receive dividends, which are considered a return of unused premium. Early in the policy’s existence, the owner often forgoes receipt of these dividends, instead adding them to the policy’s cash value in the form of paid-up additions. But the size of the dividend typically increases with the age of the policy, and policy holders may find it desirable to receive these larger dividends as an annual income source.

Rents: Passive income may be derived from real estate and equipment rental agreements. Of course, rental income is dependent on occupancy rates or how often the truck, trailer or other asset is rented. While lease agreements may establish a degree of certainty in regard to expected income, there are no guarantees that rents will be collected, or that the results will be profitable.

Royalties and fees: A royalty is a payment made to the legal owner of a property, patent, copyrighted work or franchise by those who wish to use it to generate revenues and profits. When entertainment companies publish a writer’s novel or record a musician’s ballad, the artists receive compensation for the use of their talent. A portion of every book or song sold today, tomorrow, or a decade later, results in a passive income stream to the owner of the work.

Royalty agreements are legally enforceable contracts, so the owner of the royalty has the assurance of receiving this passive income. But the amount of income will vary depending on future sales.

Limited Partnerships: This is a business arrangement in which some of the participants are investors only, and are not considered to be material participants. Thus, the income that limited partners realize from their partnerships is treated as passive income.

As a rule, establishing these streams of income is not as easy as selecting a savings account and making a deposit. The consideration of these alternatives entails careful study and usually requires some expert assistance. Given this caveat, several things should be obvious in this casual review of passive income sources:

1. The potential returns from many passive income sources are equal to, if not greater, than those offered by interest-bearing financial instruments, particularly given current interest rates. The ultimate goal of retirement planning is to produce a reliable and profitable passive income stream. Interest-bearing financial products may be used to accomplish this objective, but they aren’t the only way. It makes sense to consider the alternatives, especially given the low rates of return, and the subsequent loss of purchasing power over time.

2. The principal advantage of interest-bearing financial instruments in providing passive income is their lower level of financial risk and/or guarantees. Safety and certainty are important financial considerations, and these features explain why interest-bearing products have a place in almost every retiree’s portfolio. The suitability of including these non-guaranteed passive income programs must be weighed in light of their perceived risks.

3. You may want to consider developing alternative passive income strategies before retirement. Some passive income streams are really deferred compensation plans; the producer makes a decision when to receive income, and in what form. For many high-level executives, a deferred compensation package is a critical component in their employment agreement.

4. How you approach developing passive income for the future might affect how you save today. The conventional accumulation-distribution retirement income model has some advantages, but can also be restrictive. Qualified retirement plans have regulations that discourage early withdrawals; once the money is deposited, the financial cost of making changes may be prohibitive. Many accumulation products, such as those that invest in equities, historically deliver the best results when held for longer periods, so a decision to invest today is really a long-term decision. Research repeatedly shows that jumping in and out on these products results in poor investment performance.

For many Americans, the accumulation-distribution model is a workable retirement strategy. But the outcomes from using this approach are dependent on two variables: the amount accumulated while working, and the interest rate that can be secured to deliver the passive income. Today’s historically low interest rates have prompted many retirees to consider passive income alternatives. But even if the returns were higher from interest-bearing financial instruments, some individuals might benefit from beginning to develop other passive income sources for retirement—and even before retirement.

As you evaluate your current circumstances and your prospects for retirement, the following questions may be relevant:

Does your current employment situation offer the opportunity for deferred compensation?

Have you considered developing other passive income sources?

Do your current saving allocations allow for the possibility of establishing a passive income before retirement?

If any of these concepts pique your interest, make sure they are a topic of discussion the next time you meet with one of your financial professionals.

Elozor Preil is Managing Director at Wealth Advisory Group and Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). He can be reached at epreil _wagroupllc.com. See www.wagroupllc.com/epreil for full disclosures and disclaimers. Guardian, its subsidiaries, agents or employees do not give tax or legal advice. You should consult your tax or legal advisor regarding your individual situation.

By Elozor M. Preil

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