Passive Income: Illusions, Strategies and the Reality of Wealth Building

From the Handelsblatt archive: In order for the promise of passive income to come true, it is important to avoid common mistakes - and say goodbye to an illusion.

Passive income: A stream of money without work is possible using various strategies. Photo: Thomas Kuhlenbeck

Psychologists know that the brain reacts with feelings of happiness at the very thought of passive income. A regular stream of money without work is initially associated with effort, but is certainly possible. Handelsblatt shows how it works using four investment strategies.

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Munich. Passive income: When these two words are mentioned, most people's head starts going crazy. No more appointments, just do what you feel like doing, and all without the anxious question: “Who’s paying for it?” This is probably the appeal and success of many self-proclaimed financial strategists who loudly promote their ideas for passive income on social media.

“From a psychological perspective, the idea of ​​passive income primarily brings together three wishes: security, freedom and relief,” says Valentin Haas. The psychologist and executive coach knows this phenomenon from countless sessions: Especially when someone feels like they are permanently on the hamster wheel, just the thought of salvation gives them a brief sigh of relief.

At this moment, says Haas, our brain reacts with a feeling of happiness: the neurotransmitter dopamine is released because we believe we have found a way out - even though nothing has changed in the situation yet. “Videos, success stories and promises like: ‘Save X amount and you’ll be able to live on it forever’ provide a real dopamine kick,” says the psychologist.

But if you take a closer look at the offers, you will usually find little that is concrete. There are few questions in which concrete numbers play a larger role in the answer. Whether passive income can work depends on several factors:

personal current income and expenses,

how and according to which rules wealth is built up,

and finally, how to manage to invest assets in such a way that a steady stream of income flows from them.

In order to distinguish between the different paths to passive income, the editors of the Handelsblatt interviewed a number of experts and presented four investment strategies that can all lead to the goal.

So much in advance: The passive income, which actually flows without any action on your part, is only available to heirs. The following applies to all other people: every wealth has to be earned first. On the other hand, with the right financial planning, it is not impossible to live on this wealth.

Basically, when it comes to passive income, it is important to first distinguish whether it is intended to enable you to live exclusively from your own assets. Or whether the passive income in retirement - or even a few years before - should represent an addition to other sources of income such as salary or pension.

Passive income for dropouts

According to retirement planner Michael Huber, living exclusively from your own assets is usually only possible for people who have inherited a lot of money, founded a company or made an invention and were able to sell their work at a good price. As an employee, however, it will be difficult. “Anyone who plans to retire at 50 at the age of 25 solely through iron-clad savings and smart investing will have to make an enormous effort,” says the German head of the VZ Vermögenszentrum. This even applies to people with above-average salaries.

An example calculation that is based on quite optimistic assumptions shows how hard this path is: a young person earns 3,000 euros net at the age of 25 and their salary increases by five percent every year. At the age of 50, the person's net salary is already almost 10,000 euros.

Suppose the person lives modestly and manages to invest half of their net salary month after month in an ETF savings plan with a return of seven percent after costs. After 25 years, she has saved 1.75 million euros, minus taxes. A seemingly large sum, but one that is reduced by inflation. With an inflation rate of 2.5 percent, you will need over 2,700 euros in 25 years to be able to afford what costs 1,500 euros today.

From the age of 50, the person wants to have half of their last net income paid out month after month. That would be 5000 euros. In 25 years, however, this amount will only have a purchasing power equivalent to around 2,800 euros today. However, the person not only has to use this sum to cover their living costs, but also pay the employer's share of health insurance and other social contributions.

In order to have a buffer here, financial planner Stefanie Kühn recommends 6,000 euros per month. This “pension” must increase by 2.5 percent every year due to inflation. That may not sound like much, but at 70 the person already has to withdraw 9,340 euros per month.

Passive Income: A steady stream of income creates an enormously satisfying sense of security. Photo: Getty Images [M]

If the 1.75 million euros are no longer invested at the start of the first payout, the money will last for 19 years. With a return of 3.5 percent during the withdrawal phase, the money can last until your 77th birthday. After that, the person has to live exclusively on their statutory pension, which, because they only worked until they were 50, won't be too high.

Given the increasing life expectancy, this calculation is already very tight and, on top of that, it assumes that the salary increases steadily, that savings are made in a disciplined manner and that inflation remains fairly constant. For Michael Huber there are too many imponderables. He has his doubts, especially when it comes to the savings rate: “Expenses will increase at the latest when the person wants to start a family.”

Psychologist Haas also doubts whether it is even worthwhile to save ironically over decades in order to then go into retirement and not make too big a leap: “When you go into early retirement, you often forget to plan what you will use to fill your days off.”

Passive income as a supplement to your pension

It is much more realistic and sensible to plan passive income as a supplement to the statutory pension. High earners in particular who rely solely on the statutory pension are heading for a huge gap in their provision. By no means do all of them have company pensions as a supplement.

Many financial planners recommend that 80 percent of your last net income should be available each month after retirement. This means: start early. Anyone who manages to invest 950 euros every month for 30 years as part of an ETF savings plan with an average return of seven percent after costs can end up owning just under a million euros after taxes. On the other hand, if you only have 15 years, you have to save almost four times the amount, namely around 3,400 euros, every month with the same return in order to have a chance of making a million dollars.

One million euros is enough to pay out 3,000 euros a month for 21 years, adjusted for inflation. After that the money is used up. If the remaining money continues to be invested during this withdrawal phase with an average return of 2.5 percent, the 3,000 euros can even flow for 27 years. With a return of 3.5 percent, it will take 32 years until the money is used up. So if you start paying out your passive income at 67, you can live to be 99 without running out of money.

If the million is to be retained for 30 years without being consumed, the payout must fall to 2,000 euros per month and the remaining assets must achieve a return of 3.5 percent.

How the depot becomes a constant source of money

These calculation examples impressively show that it is worthwhile to continue investing even in the phase in which the money is to be used up. It's about the balancing act of guaranteeing secure payouts on the one hand, while continuing to take risks on the other. Because only on the stock market with its fluctuations are the returns that allow assets to continue to grow possible.

Retirement planner Huber prefers a “pension from his own portfolio” in ten-year increments because: “With an investment period of at least ten years, there have generally been no losses on the stock market, at least in the past.”

With this concept, part of the money is made available for payouts every decade, the so-called consumption part. According to Huber, we need to be defensive here. The remaining money can be invested more aggressively because it will not be needed for ten years. This so-called growth part rebuilds the assets.

Huber advises: “See the portion that is to be consumed as a fixed bond portion in your portfolio, which is continually fed from the other portion, which can also be invested in stocks.”

The ideal ratio between stocks and bonds depends on how long the money will last and whether there should be anything left over at the end. If you plan for two stages of ten years each, i.e. a total of 20 years, you can invest around 50 percent in fixed interest and invest a large portion of the remaining 50 percent in stocks.

If the total assets in the portfolio are not to decrease for three decades, the bond portion that can be consumed in the first ten years should be at least 25 percent. This ratio should be restored in the depot at least once a year.

With an investment period of at least ten years, there are generally no losses on the stock market. Michael Huber retirement planner

When asked what such a portfolio that guarantees stable payouts could look like, Christian Funke recommends filling the “consumable portion” with bonds or bond ETFs with different maturities. “The terms are coordinated so that a tranche is due every year,” says the founder and head of the Source4Alpha asset management company.

This amount can then flow into a current account or a money market ETF, from which money is regularly posted to the checking account. It is also important that as soon as a tranche has been used up, new bonds are bought again or a new fixed-term deposit is opened.

According to Funke, the part from which the “consumable part” is continuously fed should largely consist of stocks. After one year at the latest, the profits are skimmed off and invested at fixed interest rates. In the “investment part” you can also include stocks that pay high dividends in order to always achieve a certain return.

» Read also: The dividend forecasts are rising the most for these five DAX stocks

Asset manager Funke also emphasizes how important it is to have a balance between the fixed-interest and equity portions: “If one part becomes overweight, the risk increases that in bad stock market phases either payments will not be made or the payments are very secure, but the assets will be used up earlier than planned.”

Last but not least, this balancing act shows that it is possible to obtain passive income from your own assets, but it always involves a certain amount of effort.