Retire from work, but not from life.
When I was first in the Army, I was full of vim and vigor. I wholeheartedly thought that I was going to stay in for 20 years, doing great things for God and country, and then, hopefully having achieved the lofty ranks of lieutenant colonel – for, I had no delusions about my ability to make it any higher than the standard rank that almost every officer with 20 years in makes – I’d retire and start getting a retirement check at age 42. According to the Department of Defense, I could expect to make approximately $50,289 per year before taxes once I hit my 20 year mark and got out.
Those dreams were not to last. Once I got my first taste of military bureaucracy, originator of the phrase “hurry up and wait,” I changed my mind. I left the military after my mandatory five years of active duty required after graduating from West Point, always cognizant of the fact that, short of accelerating the timeline of meeting my maker or failing to get promoted along with most of my peers, I was leaving a potentially lucrative pension check on the table when I accepted my honorable discharge.
15 more years, $4,191 per month paycheck for the rest of my life.
For those of you who are wondering what you’d have to set aside to buy an annuity that provided the same pension (joint life income, 100% to survivor, no payments to beneficiaries), it’d cost $838,009.
I’m sure a lot of my peers who reached the five year mark and had the opportunity to leave the military thought similar thoughts as I did, and few of them actually ever calculate just how much they’ll need to save and set aside to create an equivalent pension. I didn’t. I just knew that I wanted to be no worse off financially for having left the Army than I would have been had I stayed in (and survived and been promoted).
Through a combination of wise financial choices, a propitious sale of a company, and, admittedly, no small amount of luck, I exceeded that goal with a few years to spare.
Having the assets and converting them into income are two different beasts.
As we’ve seen previously in my interview with Dr. Wade Pfau, CFA, Monkey Brain doesn’t actually want you to purchase annuities, primarily because of the fear that you’ll die the next day, and then, boy, will you regret that decision! He also disregards the fact that people who purchase annuities or have pensions are happier than their financially equivalent counterparts.
This isn’t an advertisement to BUY ANNUITIES NOW!!! I promise. I have no plans to purchase annuities any time soon.
It is, though, a reflection that, according to the mental goal I set for myself when I left the Army, I still had work to do.
We may be able to say that we’re financially independent and could retire early (often known by its acronym FIRE), but to actually achieve the goal of having income equivalent to or greater than what I’d have received as retirement pay from the Army would take more work, unless I was willing to convert a quite sizeable portion of our net worth into an annuity, thereby locking in the purchasing power of that capital for the rest of our lives.
I needed to go one step further.
I needed to achieve PIRE.
What is PIRE?
Aside from filling out the requisite Department of Defense paperwork, I would have never needed to lift a finger for the rest of my life to continue to receive a monthly, inflation-adjusted (supposedly) paycheck from the Army had I chosen to serve 20 years and then retire.
That is the ultimate definition of passive income.
I could have achieved a state of retiring early with passive income – Passive Income Retire Early, or PIRE.
PIRE was the goal I set for myself when I left the Army.
Maybe not the RE part, but certainly the replication of getting an equivalent retirement check by the time I hit 42 was what I had in mind.
Let’s look at a few ways in which you can accomplish the goal of achieving financial independence via passive income.
First, though, why would you rather achieve the goal of financial independence via passive income than to use the growth of your assets?
If you retire early, there are two ways that you can fund your expenses. You can either count on capital gains (put another way, growth in the price of your investments) to exceed your spending or you can live off of the income that those assets generate.
Living off of capital gains, and, in necessary cases, principal – when prices don’t rise sufficiently to meet your living expenses and force you to sell extra assets to meet the shortfall – can be a risky endeavor. It’s why the 4% safe withdrawal rate breaks down for early retirees – there are many more years where you may have to dip into that principal than if you retire at the traditional retirement age.
Therefore, for people who plan on retiring early, I recommend that they either have sufficient assets to be well below the 4% safe withdrawal rate threshold (and to read more on why I think Dave Ramsey’s 8% withdrawal rate advice is incorrect, you can click here) or they have as much of their income needs as possible met through passive income.
What do I define as passive income?
The ideal passive income is a pension. Preferably, it’s a pension guaranteed by the federal government (I won’t go into fiat currency issues, although feel free to do so in the comments). If you’re a government worker, that means either retiring from the military or retiring no earlier than age 50 from FERS. If you’re working for a company that offers a pension, then that pension is only as good as the pension funding that it has or the amount that the government insurance agency will back it up for. You can find out the pension benefit limits using the Pension Benefit Guaranty Corporation tables.
Why is this the ideal passive income? It’s because you’ll never have to lift a finger again, except to ensure that the pension provider knows where to deposit the checks. No muss, no fuss.
Let’s look at some other ways to derive passive income and their pros and cons.
Bonds and CDs
This is about the safest route you can take. Certificates of deposit carry an almost ironclad guarantee of returns (up to $250,000 per bank is protected under current laws). Government bonds have a similar guarantee.
Pros: You’ll get your money back. They’re about as rock-solid as you can get for ensuring that your money won’t disappear down some dark tunnel never to return.
Cons: Beyond what you put in, you’ll get very little back. The longer the term that you purchase, the more likely that inflation will eat your purchasing power. Corporate bonds are riskier, although you’ll get paid more; even municipal bonds carry risk (see: Detroit).
If you have enough in assets to where CDs or government bonds could provide you with enough income to live on, then you can almost certainly afford to put some of that money into other assets that have a higher probability of growing (e.g. the stock market), and fall well, well, well below a reasonable safe withdrawal rate threshold.
TIPS aren’t just what you leave at the restaurant for good service. In this case, they’re Treasury Inflation Protected Securities. These are government-issued securities designed to lock in your purchasing power at the time of issuance. You can buy TIPS in 5, 10, and 30 year terms. When you buy TIPS, you buy them at a fixed interest rate, but as inflation changes, the nominal principal in the TIPS changes so that you get an inflation-adjusted interest payment every six months. If inflation occurs, then your principal goes up, and your interest payment increases. If inflation goes down (deflation), the principal goes down, and your interest payment decreases. At maturity, you receive the higher of either the original principal or the adjusted principal. TIPS interest payments and inflation adjustments to principal are taxable for federal income tax, but are not taxed at state and local levels.
Pros: You lock in purchasing power for a set amount of time. The payments are guaranteed. You might make money at the end of the purchase period. You are protected against inflation, and, to a lesser extent, against deflation.
Cons: Only semi-annual payments. Lower returns than on other investment options. Taxable, which, for most early retirees, tax is almost unavoidable anyway.
Although I-bonds don’t pay interest payments up front, I include them here because, after 5 years, you can sell them with no penalty. There are differences between TIPS and I-bonds, namely in how they’re bought and sold, and TIPS pays interest semi-annually. There are also tax differences. Treasury Direct has a good comparison chart.
This isn’t a bad way to approach locking in your purchasing power. You won’t get any growth out of your underlying principal, but you won’t lose its purchasing power, either, removing interest rate risk as long as you’re willing to keep the TIPS to maturity.
Conservative investors like to invest in dividend paying stocks not for the potential price growth of the stock, but, rather, for the dividends that the stock pays. One example (and I’m not recommending this stock; I’m merely demonstrating it) is General Electric. Over the past five years, the average GE dividend yield – calculated as annual dividend paid divided by stock price – has been 4.11%.
Pros: Usually higher than interest rates paid on CDs or government bonds. Allows possibility for growth of underlying stock price. “Blue chip” stocks generally have steady or growing dividend stream.
Cons: Tax treatment could change: dividends once received special tax treatment and are now taxed at income tax rates. Companies ebb and flow, so dividends are not guaranteed (see: Schlumberger). Inflation is a risk if companies don’t increase their dividends to match inflation rates.
Again, this isn’t the worst way in the world to achieve passive income, although you do have to check the stocks occasionally to make sure they’re still issuing dividends. Another way to approach this is to purchase a dividend index fund.
Rental real estate
Whoa! Rental real estate? Like, landlording? Doesn’t that require work and, therefore, defeat the idea of passive income?
If you have a property manager, it’s not really work. It requires the occasional interaction with the property manager when there are repairs required, but, otherwise, once you have your rental property portfolio, all you have to do is deposit checks (assuming the property manager doesn’t do that for you, too).
Pros: If you purchase the properties properly, you can receive a higher yield than most stocks, bonds, or other investments listed previously. Rents tend to rise with inflation. The house may also increase in value.
Cons: Vacancy and repairs/maintenance could eat into your profits. If you have a mortgage, then you always have to worry about servicing the mortgage, and the government may change mortgage interest tax policy in the future. Finding houses to invest in as rental properties is easier said than done and can be capital intensive.
This is predominantly the route that we have chosen in order to meet the PIRE goal. While we realize that no investment is bulletproof, we have a good track record with our property manager, and will use a fairly conservative percentage of cash flow from the rental properties to meet our goals, treating depreciation and unused vacancy reserves as a bonus (read about how to treat bonuses in “Spend Your Bonus Before You Receive It”).
Distributions From a Company
This is what Tim Ferriss described in his book The 4-Hour Workweek (#aff): create a company that effectively runs itself and that you can pay yourself using the profits of the company. If you can get to that point, great!
Pros: It’s still your company, so you know how well it runs and how probable the payments are. Distributions can receive favorable tax treatment at long-term capital gains tax rates. If the company truly runs itself, then minimal to no work is necessary for the checks to keep flowing.
Cons: You may not have hired people who can run the company as well as you can. The market may change. It probably won’t be passive for as long or for as profitably as you hope it will, forcing you to either abandon that line of income or jump back in and actively manage the company.
This is what I’d originally hoped for when we started our last company. After a few years, I realized that getting to that envisioned promised land would take a lot longer than I expected, and I was fortunate to be able to sell most of my ownership stake. This can work for people (see: Paris Hilton), but it doesn’t work as often as people expect it to.
This is the classic equivalent to a pension. You hand an insurance company a chunk of money and they give you a steady stream of payments for the rest of your life.
Pros: Because of mortality pooling, you get a higher interest rate than most other choices. The income is pretty secure due to how the payouts are structured. They are tax-advantaged; annuities purchased outside of a retirement account only have a portion of their payments taxed.
Cons: You have to get over the annuity puzzle to buy them, and if you have other estate desires, you’ll have to account for them with money other than what you use to buy the annuity. You permanently lock in purchasing power with the annuity that you buy. Other, unexpected expenses could leave you without sufficient assets to pay them if you’re not properly prepared.
(January 2020 update) When we retired, this was the path that we went down; however, we’re too young to purchase annuities now.
As you can see, there are many ways to skin the cat when it comes to achieving PIRE. Your path may be one or it may be a mix of these.