- Understanding the benefits and risks of the notable options for passive income:
- Cash & Cash Equivalents
- Dividend-Yielding Stocks
- Real Estate
- Business Ownership Through Private Equity/Private Placements/Local Investing
In Part 1, we laid out the rationale for why investing for income is becoming more important than ever as the Era Of Gains draws to an end.
Those who put in place a diversified portfolio of relatively low-risk passive income streams, inflation-adjusting and tax-advantaged wherever possible, should be much more financially resilient than the general masses after today’s Everything Bubble ruptures.
The good news is that there’s a variety of options worth considering when constructing such a portfolio of income streams. Here in this primer, we identify many of the most noteworthy along with their general benefits and risks.
The challenge, of course, comes in the application of this information. Which options are best for you, given your specific situation, needs, goals, and risk appetite?
And as always, we recommend working with a professional financial adviser to build an investment plan customized to your own needs and objectives. (If you do not have a financial adviser or do not feel comfortable with your current adviser’s expertise in the market risks we discuss here at PeakProsperity.com, consider scheduling a free consultation with our endorsed adviser)
Suffice it to say, any investment ideas sparked by this report should be reviewed with your financial adviser before taking any action. Am I being excessively repetitive here in order to drive this point home? Good…
With the above said, the primer below should give you plenty of food for thought for how you may wish to design your own income-generating portfolio. Explore the options of greatest interest to you, and feel free to let us know in the Comments section below which ones you would like to see explored in further depth on PeakProsperity.com in the future (dedicated articles and/or podcasts and webinars with experts).
“Financial independence” is defined by most as having enough passive income to cover all of your living expenses. While a worthy goal for all of us, even partially achieving that state will make your life tremendously less stressful than the hundreds of millions (in the US alone) who fall far short of it — and will only fall farther behind during the next deflationary wave when asset prices fall, job losses spike, and government subsidies become more scarce.
A Word On Timing
“Buy low, sell high” is the age-old mantra of the investor looking to profit from big gains.
Over the past era of central-bank blown bubbles, almost any time has been “a good time to buy” because the huge amounts of liquidity have pushed asset prices ever-higher. Today’s prices have almost always been lower than tomorrow’s prices for nearly a decade now, embolding investors to see every dip as a buying opportunity (BTFD!).
As stated, we think that the long-running Era of Gains and its related hubris will vaporize when the current bubble pops, sending prices plummeting.
The primer below walks through a number of assets that, when purchased, entitle the buyer to income produced by the underlying assets. While that income is desirable (and likely to become even more so for the reasons enumerated in Part 1), it’s important to keep in the mind that the underlying assets have value, too.
So it’s important not only to ask: Am I receiving an acceptable amount of income? when looking at these investment options. You also need to ask: Am I acquiring this income at an acceptable price?
Simply put, should a major market correction/crash occur, income-producing investments should be a better value than they are today. You’ll be able to secure the same amount of income (or more) at lower prices.
While no one has a crystal ball that can predict exactly where market prices are headed and when, there is currently a preponderance of evidence that we are in the final stage of one of the most over-valued periods in the history of financial markets.
So there’s a good argument to be made for waiting until a market-clearing event occurs before deploying too much of your capital towards income-generating assets. Playing it safe on the sidelines and using your time today to do your research and identify your target list of purchases is a sound strategy.
First, Don’t Ignore Your Active Stream(s)
Before we get to the passive options, be sure not take your eye off your active income stream(s).
For most people, your primary job will be your greatest source of annual income. So nurture that as best you’re able to. Make sure to stay sufficiently skilled and respected in your field, in order to be able to command a fair rate for your services up until the time you stop working.
Do the math. For as long as you expect to keep working, how much income can you expect to bring in?
Now see if you can slant the odds to your favor. Could you boost that income total? Perhaps by:
- Increasing your salary — advancing via promotion, acquiring more marketable skills, transferring to a higher-paying job
- Working for longer — would you benefit materially from working a few years longer at your primary job than you initially planned, perhaps on only a part-time basis?
- Adding a side gig — picking up part-time/flex work when convenient (consulting, project-based work, Uber, etc)
- Additional spousal income — does your S.O. have the potential to work more/earn more?
Any additional increase in your total active income will reduce your demands for passive income. You might choose not to make this trade-off for quality of life or other reasons, but it’s worth going through the exercise.
And obviously, today’s income only helps out your future prospects if you save it. So creating a monthly budget to know accurately what your current savings rate is (both in total $ and in % of income) and then challenging yourself to increase it going forward is another key discipline to adopt.
Investing For Passive Income
First off, estimate how much income you can expect to draw annually from any retirement vehicles you have in place. As we detailed in our recent report on retirement, for the vast majority of folks, these will be insufficient — likely much to insufficient — to cover projected annual living expenses:
- Social Security — nearly all US seniors will qualifiy for Social Security payments. Your payments will largely depend on the amount of SS taxes you paid into the system during your career, with a current maximum monthly payout of $3,750. Social Security payments sometimes are increased annually by a cost of living adjustment (COLA), but the pace has been very slow historically vs actual inflation (for the first 40 years of the program, there were no adjustments made for inflation). There are mounting concerns about the long term dependability of Social Security, as the SS fund itself has been fully raided over the years to pay for Congress’ wars and programs.
- Pensions — pensions, especially private-sector ones, are not nearly as prevalent as they were in the past. If you have one, contratulatons! It’s the equivalent of having several million in T-bills at today’s current rates. But not all pensions are created equal, and many pension plans are dangerously underfunded or destined for insolvency. If you are expecting to receive a pension, be sure to ask your plan for the details on its current funding ratio (anything under 80% is concerning) as well as its future funding projections.
- Retirement plans (401ks, IRAs, etc) — for those not counting on a pension, a rough rule of thumb is to have 25 times your annual income saved up by the time you want to retire. Most Americans fall far short of this goal. How short? Well, the median amount saved in a retirment plan among working US adults, even among the near-retirement 55-64 age cohort, is $0. How far short are you right now?
Cash & Cash Equivalents
These are the “safest” investments for income (i.e., least likely to result in the loss of your principal). As such, their expected returns are the lowest vs other options.
- Bank savings accounts — The most liquid way to store cash. During the record-low interest rates of the past 7+ years, bank savings rates have been insultingly low, around 0.06%, vastly underperforming inflation. Savings rates are getting slightly better, with a number of banks offering teaser rates (usually only for new deposits) as high as 2%. Cash stored in a bank savings account is subject to any bank failure/bail-in risk higher than the FDIC coverage limit.
- Money Market accounts — Banks and brokerage firms both offer these MMAs to their customers. They offer slightly higher interest rates than traditional savings accounts because they demand a minimum balance and limit the number of withdrawals a customer can make in a given month. As with savings accounts, MMAs are subject to any bank/brokerage failure higher than the FDIC/SIPC coverage limit.
- Bank Certificates of Deposits (CDs) — Similar to a bank savings account except your money is ‘locked up’ with the bank for a period of months (most commonly 1, 3, 6, 12, 24, 36, 48 & 60). For the right of using your savings during this period, the bank pays you a higher interest rate. The best rates on the market today range between 0.6% for 6-mo CDs up to 3% for 60-mo ones. Cash stored in a bank CD is also subject to any bank failure/bail-in risk higher than the FDIC coverage limit.
- US Treasury Bills — Currently, you can get notably better returns from 4-week to 1-year T-bills than from bank CDs or savings. Current yields range between 2.2%-2.7%. Moreover, you avoid the risk of bank failure/bail-ins. You can purchase T-bills directly from the US Treasury through its TreasuryDirect program, which we’ve written about extensively here. As long as you hold them to maturity, which is easy given their short durations, you’ll receive the promised yield (usually paid up front) and all of your principal back. Income received from T-bills is tax-free at the state & local levels (though remains subject to federal tax).
These are debt instruments (essentially an IOU) that give you a regular payment (called a coupon) while the debt is outstanding. You can either hold the bond all the way to its maturity, at which time you’ll receive your principal back, or you can sell the bond in the open market at its current market price.
A key fature to know about bonds is that they are highly sensitive to interst rates. As interest rates go up, bond prices fall.
Owning a bond is attractive for the income it kicks off. Your money is “making money” for you. But should interest rates rise substantially after you buy a bond you have to be aware of the implications. If you sell the bond before its maturity, you very likely won’t get all of your principal back and experience a capital loss.
Bond math can be a little tricky, which is why we highly recommend working under the guidance of an experienced professional financial advisor when developing the bond part of your portfolio. (for the DIY crowd, here’s a handy online calculator for running sensitivities)
- Sovereign debt — these are longer-term (>1 year) notes and bonds issued by the governments of the world (e.g. US Treasury bonds, UK gilts, German bunds). Their markets are usually highly-liquid, and default risk is very low for the major developed countries. The longer the bond duration, the higher the return (the 30-year US Treasury bond is yielding 3.4% right now). And the riskier the country, the higher the return (Argentina’s 10-year bond is currently yielding over 20%). Those investing for dependable income should stick to the most stable countries.
- Municipal debt — these are bonds issued by a state, munipality or county to finance its capital expenditures, usually tied to a public project like a roadway, school hospital, etc. Income from many muni bonds are exempt from federal taxes. While generally considered ‘safer’ debt to hold vs private debt, munis can be defaulted on (e.g., Detriot, Puerto Rico) and may experience lower trading liquidity.
- Corporate debt (above BB/Ba rating) — companies raise debt for all sorts of reasons. An since companies don’t have the power to print money like sovereng government or tax their citizens like munipalities, corporate debt coupon rates are higher. The major ratings agencies like Standard & Poors and Moodys evaluate how ‘risky’ these companies are — the more risk, the higher the return the bonds should offer. It’s important to know that if the company issuing the debt gets into trouble, such as bankruptcy, as a creditor, you could lose some or all of your principal (though any funds will be paid to you before the company’s stockholders). Again, those investing for dependable passive income should largely stick to debt issued by blue chip companies with healthy balance sheets.
- Diversified short term private mortgage funds — these are short-term private loans made for the purchase and/or renovation of real estate. These loans are secured by the underlying real estate assets, are typically 1-3 years long, and currently have interests rates ranging between 7-12%. They aren’t for everyone; only accredited investors shoud consider making these loans directly (most won’t let non-accredited investors participate). More on these loans can be learned here.
- High yield bonds and peer-to-peer lending — these are debt/loans the offer higher interest payments because, surprise, they come with higher default risks. High yield bonds (ratings BB/Ba or lower) are also referred to as “junk bonds” and are not a good fit for an income portfolio that prioritzes safety of that income stream. Those with sizable wealth and an already widely-deversified portofolio may want to explore holding a small percentage in a high yield ETF like JNK to get a little extra yield and a little extra diversification, but that will be a minority of folks reading this. Peer-to-peer lending platforms like Prosper have offered historical average returns of 5.5%, but are so new that they are unfamiliar to regulators and untested by a major market correction/recession. Proceed with caution if you explore this space.
Dividend Yielding Stocks
While stocks are currently at risk to lose a lot of their value in the event of a major market correction, after that correction, there still will be operating companies and there still will be a functioning economy (and if there isn’t, we all have bigger problems).
And even if the next decade doesn’t see much price appreciation in stocks, there will be solid companies offering dividends. It’s important to keep in mind that nearly 70% of the stock market’s total return over the past 40 years has come from dividends vs price appreciation, as hard as that may be to believe.
So, presuming the Everything Bubble bursts in the next 0-3 years, there should be a good opportunity to purchase income at much better valuations than today. And still have the potential for share price appreciation on top of that.
There are number of ways to get equity income in the public markets:
- Dividends from Blue Chips & Utilities — Look for stable, long-standing businesses in the “cash cow” stage. These are stocks that tend be a lot less speculative with dependable positive cash flows. There are a number of lists screeners out there you can find online to identify the best prospects. Today’s popular blue chip stocks are offering dividend yields in the 5.5-7% range. Similarly, large utility companies tend to offer reliable dividends while remaining lower risk (though risk can sometimes strike — just look at PG&E which has recently lost nearly 50% of it’s stock price due to it’s supposed culpability for the recent massive California wildfires).
- Income funds — Many investors prefer to avoid the hard homework and uncertainly involved in buying specific stocks and instead prefer to buy shares of income funds, where the index/fund manager does the legwork for them and rebalances the fund over time. Income funds can specialize in generating income from dividend stocks, bond yields, or a mixture of both.
- Preferred stock — preferred stock is a class of stock that has higher priority (e.g., liquidation rights) than common stock. It often comes with a higher dividend than offered on common shares. While you can buy preferred shares directly, they’re a little tricker to obtain for the average investor. Income investors may find it easier and less stressful to instead buy shares in a fund that owns preferred stock across a number of companies sectors. PFF is the largest such ETF on the market, currently paying a yield of roughly 5.75% (PGX and FPE are other large peers).
- Covered calls — If you happen to own a large position of a certain stock, say, received as a grant from the company you work for, there’s a way to generate income from that position by writing covered calls. By doing this, you’re selling call options against your holdings — a bet that your holdings are not going to spike up in price anytime soon. Those who buy your call options pay you today for that privlege. If the stock stays roughly flat or declines, you still own all your shares + the income you received. However, if the stock spikes above the exercise price on your call, you are obligated to sell your shares at the exercise price: meaning you’ve lost the upside vs the higher new price. This is a good solution for folks sitting on a large position they’re not willing to part with yet, but who want income with very limited downside. Or, as with preferred stock, you can own shares in a fund (PBP is an example) that is fully-focused on writing covered calls against its own positions.
Investing in income-generating properties is one of the most tried and true formulas for accumulating wealth over the centuries.
That remains true today, although just as for the publicly-traded markets, timing is important. Right now, property price bubbles are rampant again around the world, and as we’ve been covering here at Peak Prosperity, unafforabaility, rising interest rates, and increasing controls on global capital flows currently appear to be causing those markets to nose over.
Those with an income focus (vs flipping) may have the opportunity to pick up excellent values if real estate prices experience another correction like they had in 2007-2009. And should that happen, and the Fed then drop interest rates again in attempt to goose the economy, there may be a rare window to purchase at both low prices and low mortgage rates. Such a window of opportunity won’t last long; those who are positioned in advance will be the ones to take advantage of it.
We here are Peak Prosperity believe that real estate as an investment class has a role to play in many people’s portfolios. Expect to see more dedicated articles, podcasts and webinars on the topics below in 2019.
- Direct ownership — this is you buying and managing properities yourself. It can be lucrative and rewarding, especially as your property portfolio and its associated income grows. There are lots of favorable elements in current tax laws that are very preferential to property owners (bonus depreciation being just an example) that add to real estate’s wealth-building benefits. But it’s certainly not for everyone; not everyone was meant to be a landlord. Good resources for those looking to learn more about how to successfully invest in real estate are this book and this podcast series.
- Participating in a syndicate — you can also own specific real estate property much more passively, as an investor in a syndicate. A sydicate is a private deal where the managing partner finds a property and buys it with funds from a pool of investors. S/he manages the property for you; you simply collect a check of your pro rata share of the income (and any pro rata tax breaks) that the building spits off. There are lots of books written on how to participate in, or lead, a syndicate; and a good seminar on the topic is offered by our friends, The Real Estate Guys.
- Real Estate Investment Trusts (REITs) — these are larger funds that own and manage holdings of income producing real estate. Most are public and you can buys shares in them in the open markets just as you can a standard mutual fund. These are good vehicles for folks looking for income, want broad diversification (number and types of properties, geographies, etc) across real estate as an investment class, and who don’t want the obligation of property management themselves. They are also extremely liquid compared to direct ownership and syndicates.
Business Ownership Through Private Equity/Private Placements/Local Investing
Owning a stake in a private (i.e. not publicly-traded) income producing business can be achieved via a number of routes. Many brokerages/financial advisory firms can highlight private placement offerings to their clients who qualify. Those with high enough net worth can invest directly with a private equity firm; the rest of us can buy shares in the publicly-traded firms that make private equity investments (like Blackstone and KKR).
Many commodity-based companies like mines and energy plays raise capital in private deals. At the resource conferences that Chris and I attend, there are always lots of these companies looking for investors. Caveat emptor; there are a lot of projects that will never pan out. But those that do can be extremely lucrative for a long time. A prolific oil & gas well can yield generous annual income for years/decades, along with tax breaks against that income.
And in your local area, business brokers and service clubs (like Rotary) can connect you with stable, profitable businesses in your area that are raising capital. You can even knock on the door of local companies you like and simply ask what their funding needs are — many of these smaller deals are started on and maintained by relationship. Yes, there’s a whole different set of dynamics when investing like this, but with rigorous enough due diligence, you can have an investment where you have more visibility and influence than any publicly-traded stock you’ll ever own. Plus, by strengthening the prospects of a local business, you’re strengthening the resilience of your community.
Royalties are payments you receive for allowing someone to use property that you own or control, for a period of time. Most often, this is on intellectual property: copyrights, patents, and trademarks. Music, artwork, franchises, mineral rights, etc are common examples.
Why royalities? Royalites are not very correlated with the financial markets, which is good for diversification. Payments are a direct function of how often the property is used (i.e., how popular it is). For example, every time a song is listened to, a royalty payment to its rights owner is incurred.
Those interested in owning royalties should not make them a sizable portion of their portfolios until they have suffience experience with them as an investor. To learn more about the dyanmics of how they work and the pros and cons to mindful of, read this article.
Royaly-producing assets can be purchased through private transaction or via exchanges. A prominent music exchange, RoyaltyExchange gives investors the options to purchase individual assets directly, or to participate in syndicates with other investors to own a slice of large assets (multi-million$).
Annuties have been around since Roman times. They are a contract, typically between you and an insurance firm, where for a lump payment (or series of payments) today, you purchase a guaranteed future revenue stream.
There are various types of annuities, most commonly devised for principal protection, lifetime income, estate planning or long-term medical care cost coverage.
Annuties can be structured a number of ways, too — so this sector can be a bit complicated. Payouts can start immediately or be deferred by decades, can be fixed or vairable, and can be associated with tax breaks and/or life insurance aspects. It’s highly recommend you have an experienced financial advisor to guide you when navigating the many offerings here.
A lot of advisors have reservations about annuities, and rightly so. Commissions and annual fees can be rapciously high (and hidden). There are early withdrawal penalties. The income stream “guarantee” is only good as long as the underlying insurance company remains solvent. Fixed annuity payouts become less attractive as interest rates rise. Variability annuities are subject to market risk. In most cases, the expected return from annuities is lower than investing the same capital directly into the markets.
But to this last point: if we are indeed entering an era of “price appreciation drought”, when the market return could be 0% over a decade, a modest but steady payout stream will look awfully appealing in comparison.
Those looking to learn more about annuities should read this primer first, and if further interested, schedule a talk with a professional financial advisor with at least a decade of experience dealing with them for clients.
Be Sure To Also Focus On Minimizing Your Cost Footprint
All the above focuses on the income side. Focusing on the costs side is just as important, as you make your income go farther the fewer demands you place on it.
And unlike the markets, which no one can predict; you have much more control over your costs.
First, revisit your annual budget to make sure you have crystal clarity on all your living expense line items.
Then challenge yourself to reduce extraneous expenses. What expenses can you cut back on/remove entirely while putting the difference into savings, without suffering an unacceptable drop in quality of life?
Most people actually find that by economizing they simplify their lives, thus enjoying higher savings and peace of mind together.
This process may force some emotion-packed decisions, especially when it comes to big expense line items like housing costs.
- Does downsizing to a smaller property make sense? It usually does for empty-nester couples whose adult children are out of the home.
- Would moving to a more affortable region (lower housing values, lower property taxes, lower/state income tax, etc) materially extend the years covered by your expected passive income? If you live in states like California, Illinois, New Jersey or Massachusetts, the answer may very well be “yes”.
- Do you have family/friends who would be willing to co-habitate with you? Multi-generational living was the norm in previous generations. We’re big fans of it here at Peak Prosperity for its social and cultural benefits, beyond the substantial cost savings it can offer.
For additional ideas on ways to reduce your living expenses, read this.
Finally, adopt Thoreau’s mindset. He had a wonderful quote that each of us can benefit from remembering: I make myself rich by making my wants few.
The less you desire, the less you need. So focus on the things that truly matter (relationships, connection with nature, time for oneself, etc) — you’ll find most of them don’t require a lot of income to maintain. And let the rest fall away.
If you’re reading this — congratulations! You’ve successfully made it through quite a long report.
The big takeaways here are that income-investing is becoming much more important, particularly for folks approaching retirement age — and the time to start developing your strategy for it is now. You want to be prepared to act with decisiveness and clarity not if but when the Everything Bubble finally bursts.
The litany above should give you hope that there’s a wide range of solution options above to evaluate and consider. Again: work with an experienced professional financial planner, especially regarding options with which you have little to no prior familarity.
Whether you work with them or not, the advisor Peak Prosperity endorses, New Harbor Financial, will be happy to address any questions you have about your retirment/passive income plans. You can schedule a time to talk with them (completely free) by clicking here.
And if you’d like to see future reports/podcasts/webinars on this site offering a deep dive into any of the income-generating asset classes mentioned above (or any we neglected to list), please let us know in the Comments section below.