The freedom that comes from having a passive income stream is wonderful. Whether you have enough passive income to stop working completely, or it is fuelling your savings engine, passive income can give you more free time. If you understand your financial needs and plan well enough, then a passive income stream can last as long as you need it.
While passive income is a powerful tool in your financial strategy, there are some key concepts that you should understand so you can plan effectively.
First, you need to understand is what passive income is. There are several definitions. For this discussion passive income is income from a source other than your pay cheque. This includes income like: rental income, dividends, and interest.
Inflation and Passive Income
Second, you need to understand that the buying power of passive income is eroded by inflation. This is particular to passive income that produces a fixed sum. Chart 1 below illustrates the effect of inflation on the purchasing power of a fixed annual amount of a passive income of $50,000. This is illustrated by the green line. The red line illustrates the effects of three percent (3%) inflation on the purchasing power of the passive income.
Chart 1 - Effect of Inflation on Purchasing Power of Passive Income
Discussions of passive income often ignore this point. But, it can have a significant effect on your ability to achieve your lifestyle and financial goals. For example, if your goal is to quit your job and live on the annual passive income generated from the five percent (5%) interest on a $1,000,000 investment, then by the twentieth year, your purchasing power has dropped from $50,000 to $27,190. This assumes inflation is a consistent three percent (3%) a year. The problem is that your income does not increase to counter the effects of inflation. That is why an indexed pension is so desirable – compared to non-indexed pensions. With an indexed pension the purchasing power remains almost constant as the years pass.
To beat the effects of inflation your passive income must increase each year by the amount of inflation. Chart 2 shows the result of a steadily increasing income that results in consistent purchasing power.
Chart 2 - Constant Purchasing Power and Increasing Passive Income
For most passive income strategies this ever increasing curve is difficult to achieve. As mentioned previously, the indexed pension is an example of passive income that does achieve consistent purchasing power. Rental income can also achieve this result if the rents can increase at the rate of inflation.
Another way to beat inflation is to start with a higher rate of return or larger initial investment, and use the excess income in the early years to steadily increase the investment size. Chart 3 below shows the ability to maintain constant purchasing power by reinvesting a small portion of the excess passive income each year. To achieve the results shown below, the interest rate was increased from five percent (5%) to six and a quarter percent (6.25%).