Tuesday, May 11, 2010

All About Income

In my previous posting, I talked about simplifying financial planning to just 4 variables : Income, Expenditure, Savings and Returns.

Today, I thought that I would just explore a little more on Income.

Earned Income and Passive Income

Many people are only familiar with earned income which is the salary they draw from their day jobs. Others supplement their income by holding part-time jobs (e.g. tuition). Since most people are familiar with earned income, I thought that it might be timely to highlight another source of income which is passive income.

Passive income is simply money that flows into your pocket without you having to work for it. This can be obtained through dividends, annuity payments (CPF Life), or royalties (e.g. from books you have written).

Discovering that one can rely on multiple streams of income instead of a single source of income can be a relief especially in times of job loss or change of jobs. By not relying solely on a single source of income, you sort of diversify your "risks".

Of course, conventional wisdom still holds that you can actually just rely solely on your salary if you are really good at your work and the marketplace values your work highly. This include highly paid atheletes, musicians, directors, etc.

So whether you should rely solely on a salary or on multiple streams of income is a choice you have to make based on your own personal situation.

Protecting Your Income

We all take our salary for granted at times.

It is important to realise that there are certain events in life that might render one jobless. This might include unfortunate events like death, disability, illnesses, accidents or just hospitalisation.

It is thus important to realise the need to hedge against these risk by protecting any loss of future income that might be earned by you. Today, insurance companies are willing to bear this risk for you. You can thus protect yourself and your family from any loss of income by buying insurance.

Protecting your income can also be through simple steps like going for personal upgrading and development courses to ensure that your remain employable.

RETIREMENT INCOME

Perhaps the most worrying trend is that Singaporeans do not plan actively for their retirement.

During retirement, most people will not be earning a salary as they stop working totally. Without an income, they either have to rely on their savings or passive income to support their lifestyle during their retirement years.

CPF Life is an example of relying on one's savings to ensure a stream of income is present for one during retirement. The reason why CPF Life was initiated was to ensure that Singaporeans have enough savings to last them through their retirement years.

If one relies solely on their earned income, it is necessary that they realise this fact which I have illustrated below. Take Mr ABC who plans to retire at age 60 and who has an expected life expectancy of 80 years.

Mr ABC's projected income flow:

Age: 25 - 35 Annual Salary: $50,000
Age : 35 -45 Annual Salary: $80,000
Age : 45 - 60 Annual Salary : $120,000
Age : 60 -80 Annual Salary : $0

For a good twenty years (age 60 to 80), Mr ABC will not be drawing an income. He will need to rely on his savings over the past 35 years of his working life (age 25 to 60) to support 20 years of retirment.

If he is fortunate enough to live till age 95, he will have to depend on 35 years of savings to support 35 years of retirement!

Adding up his total income over 35 years, he can expect to draw a neat sum of $3.1 million dollars over his entire working life. Without taking returns on investment and inflation into account, if Mr ABC saves only 10% of his income, it would leave him with $310,000 to spend over the "worst case" scenario of 35 years in retirement.

That works out to around $8,900 per year or $740 per month.

Can he survive on that amount?

4 comments:

  1. Hi FF,

    Hmm, I don't like the definition of your passive income. To me, I think passive income means that you only have to spend a one time effort to secure it, thereafter, you do not have to be physically there to earn that income. That's how I see active or passive income - whether you need to be there physically to earn it. Not being there physically doesn't mean that you don't have to do any work.

    As for ABC, I think if he had to spend 35 yrs of his retirement by working for 35 yrs, he had to save 50% of his income. This implies that for every 1 month of salary he earns, he's also 'working' to earn him 1 month of salary after he retires.

    Since he's saving only 10%, that's going to be tough. He had to increase his savings during his working years, or decrease his expenditure during retirement years.

    740 per month in 20 yrs time is definitely not enough. It's around $410 per month, after taking into account inflation. Very tough living.

    ReplyDelete
  2. Your investing that will determine how well you you can retire unless you are high earners who are low spenders then you can count on saving alone.

    Passive income is money received on a regular basis, with little effort required to maintain

    http://createwealth8888.blogspot.com/2010/04/saving-matters-but-investing-determines_21.html


    http://createwealth8888.blogspot.com/2009/01/active-income-and-passive-income.html

    ReplyDelete
  3. Hi,

    I came across a nice article before.

    http://wealthbuch.blogspot.com/2009/10/enlightenment-about-passive-income.html

    It's really nice. Not written by me.

    ReplyDelete
  4. hi LP,

    Thanks for that definition. Haven't really thought of it that way before.

    ReplyDelete

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