Myth & reality of passive income

• Passive income as a concept of money management and personal finance is among the most searched topics on Internet.
• It seems every other person wants to quit his job or business and enjoy life with passive income. Right?
• But how many of us really understand what passive income is? Is passive income easy money? Is it a substitute for active income that is earned through hard work?
• Post-Covid, stock market gains seem to have fuelled the misconception that one can survive with passive income, without undergoing the daily grind.

Who wouldn’t like to enjoy life without paying the price of all the hard work? It is no surprise that a lot is being debated about on the importance of passive income, which has suddenly emerged as a game no one wants to miss out on. Of course, the uncertain job market in recent times has fuelled the dream of an average Indian to look for passive income. It is further fuelled by financial influencers who have the explicit motive to sell financial products.

The larger question is whether there is an adequate understanding of passive income. Is it really a substitute for active income? Can you reach a stage of earning passive income without working on your skillsets to earn active income?

There are some deeper questions that need to be answered.

Making sense of it

The definition that passive income is income that one generates with little to no labour is not true in the real context. Passive income also requires some labour/enterprise that rewards you later without actively working for the same. For instance, you take pains to write a book and if that rewards you in terms of royalty in the years ahead, it is passive income. Similarly, your investments with the money that you earned through active income could be a source of passive income if invested wisely.

Is it easy money?

Passive income is not at all about getting easy money without doing anything. Such misconceptions are a result of unexpected gains from the stock market post-Covid. That, by and large, is an exception. Passive income through lottery gains is more of wishful thinking than reality. To earn passive income, one needs to invest either time or money. And in order to invest money, one needs a sound active income that allows for saving after all necessary expensess.

The Importance of it

Passive income is your lifeline in an emergency, during a crisis or when you are no longer capable of working, say post-retirement. For example, two employees (A and B), each with a salary of Rs 1.5 lakh per month, were sacked after the company went on a cost-cutting drive.

With almost no savings or backup plan, A had no option but to take up another job, with a 50 per cent salary cut. It’s not just a compromise with one’s salary, lifestyle and expenses, but what is even more problematic is the fact that he will need a 100 per cent salary hike to get back to his old salary slab. This kind of hike is not easy in today’s bleak employment market.

Meanwhile, B had been investing Rs 50,000 per month through SIP (Systematic Investment Plan) for the past 15 years. At a modest rate of interest of 12.5 per cent compound annual growth rate (CAGR), B had a corpus of close to Rs 2.5 crore. Once out of the job, he switched the SIP into SWP (Systematic Withdrawal Plan) and started getting an amount equivalent to his previous salary of Rs 1.5 lakh per month. Calculating further gains from the same rate of 12.5 per cent, the corpus would continue to add more than Rs 13 lakh yearly, while generating a passive income equal to one’s salary. With such a cushion, one is financially free to take a sabbatical and look for a job on one’s own terms, or even experiment with something new. Passive income gives you choices, freedom and control over your own destiny.

The different types

Passive income could be anything that rewards you for your investment done earlier, with either active income or a side hustle. There are six major passive income sources — interest; dividend; capital gains; rental; profit; and royalty income.

Real estate

This is the most frequently asked question. Of course, Robert Kiyosaki, who believes in cash flow as passive income, and not capital gains, has so eloquently described rental income as a wealth-building source. In the West, where rentals are high, rental income is part of retirement planning, in general. Unfortunately, this concept doesn’t work in the Indian context. With inflated property prices and rental yield in the range of 2-3 per cent, the borrowing cost is at least 500 basis points higher than the rental returns. Rental income would qualify as a prudent advice for passive income only when the rental returns are higher or equal to the property finance rates.

For example, in Dubai, the home loan rates vary between 2.75 per cent and 4 per cent, and the rental returns are 9-10 per cent. Only with this kind of returns would a property qualify as passive income. I am not calculating the capital gains here, because you need to sell your asset to get capital gains.

‘FIRE’ aspiration

Youngsters today want financial independence, and that is alright. But isn’t it amusing that they also want to retire in their 30s and early 40s? Global exposure has made them aware of the FIRE (Financially Independent Retire Early) movement. Right? But how many of them really understand what the FIRE movement has been all about? More importantly, what is FIRE in the Indian context? Is it as much relevant in India as is globally celebrated?

Before one decides to slog to generate passive income, and then settle with FIRE, one needs to know that FIRE has actually ‘BACKFIRED’ in many developed countries as well. People who decided to quit their jobs in the late 30s and early 40s could only calculate the financial corpus and passive income. What they failed to calculate was the ever-increasing inflation and emergencies that wipe out the very same capital that looks attractive when financial planning is being done on paper and in ideal-world conditions. Moreover, the western concept of FIRE is not to retire and be a couch potato, but move from stressful work to do something that they love, and which could also give them some side income.

Key takeaways

• While the importance of passive income can’t be overstated, it must be understood in true context. The financial influencers who try to hardsell products often mislead the audience, giving the impression that passive income is a substitute for active income.
• One can create passive income only with an active income. Passive income, at best, is a cushion in an uncertain economic environment. It saves you in an emergency, and offers the flexibility to experiment.
• While one must aspire to reach a stage where passive income exceeds active income, one should also be careful about the fact that one’s productive life is not wasted just because there is some passive income in hand.

— The writer is CEO, Track2Media