8 Advanced Strategies to Generate Passive Income In Retirement - Part 2
In our Part One article on passive income strategies, we discussed 7 Basic Strategies to Generate Passive Income In Retirement. That discussion was the first of our two part series on retirement income strategies.
In that article, we talked about the importance of focus, understanding the main assets that generate passive income, and several more fundamental strategies upon which to build your retirement income foundation.
This week, we reveal eight additional advanced passive income strategies and options to further accelerate your retirement income goals.
In this Part Two article in our passive retirement income series, we discuss each additional advanced passive income building strategy including important details, the pros and cons associated with each option, and even when to consider using each strategy in your own portfolio.
Generating passive retirement income from your investments is critical to enjoying good financial health and is also central to making sure that your investments really work for you before and during your golden years.
The reason that positioning yourself for passive income on your investments is so important is that as you approach retirement, you need to have created enough regular income coming in to comfortably cover your expenses and supplement your lifestyle when you are no longer getting earned income from employment.
Only with a good passive income generation strategy implemented within your portfolio can you really enjoy your retirement years with ample freedom and security.
Any passive income investment strategy, including all the strategies we cover in our two part series, must be able to handle and fund your expenses to withstand the challenges of:
- Inflation which is a steady and gradual increase in prices that tends to happen over time. Remember how much milk and gasoline and rent used to cost thirty years ago? These items are much more expensive today because of inflation. Inflation obliterates the purchasing power of your savings and investments. Because of inflation, if you have mostly fixed income streams such as bank accounts, CDs, or bonds, or even large amounts of cash you are not protected against rising costs which will gradually erode the value of your savings like a headwind that never goes away. Learn more about factoring inflation into the retirement equation in our article Deciding When to Retire: When Timing Becomes Critical
- Increased health care expenses which are one of the most predictable expenses in retirement. Health care costs in the US have tended to rise much faster than inflation and your retirement income strategy must be able to fund a portion of these rising expenses (at least those not covered by Medicare)
- Market volatility which is the fact that markets and stock prices are volatile in the short-term, though they tend to rise in the long-term. Passive Income from investments helps to buffer volatility and can help you ride out market dislocations. You can wait for a recovery and even reinvest some of your cash flow into lower market prices while collecting your income. As I write this article, the US is going through the Corona-virus disruptions that accelerated in March 2020 and are continuing into April. Those with passive income are better positioned than those without
Without any further delay, let's dive right into our discussion of the eight advanced passive income strategies.
Advanced Strategy #1 - Consider Adding Convertible Bonds to Your Portfolio
Convertible bonds are a lesser known niche within investment markets. Unlike regular bonds, which offer only a return of interest and principle, convertible bonds have a unique feature.
Just like regular bonds, convertible bonds promise to pay you back with some interest and a return of your principal at maturity.
However, unlike regular bonds, convertibles provide an option to convert each bond into a predetermined number of shares of the company that issues the convertible bond.
Because of this unique conversion option, convertible bonds are considered hybrid securities offering the “best of both worlds” i.e. income, downside protection, and upside participation.
The bond part gives the investor downside protection and income, while the option to convert into equity gives the investor the possibility of higher growth and higher average returns. Each bond has its own conversion ratio (number of shares of common stock the bond can be converted into) and requires research and expertise to add to your portfolio.
Types of Convertible Bonds:
- Regular Convertible Bond - Investors have the choice to hold the bond until maturity or convert it to stock (typically at any time prior to maturity that they choose) so conversion is optional and not mandatory. If the stock price has decreased since the issue date, the investor can hold the bond until maturity and get paid the face value. If the stock price increases, the bond can be converted to stock, thereby getting more than the face value (sometimes much more).
- Mandatory Convertible Bond: Required to be converted by the investor at a specific conversion ratio and price level. The investor typically collects a greater distribution yield under the mandatory conversion date. When we speak of opportunities in convertible bonds, we are usually referring to regular convertible bonds
Pros and Cons of Convertible Bonds:
- Investors receive fixed-rate interest payments with the option to convert to stock and benefit from stock price appreciation. If the price of the underlying stock that the bond can be converted into increases above the conversion price specified at the issuance of the bond, the bond’s price can also rise well above the original cost of the bond
- Investors get to own a less risky security than the stock of the same company because in an economic downturn, bondholders have seniority and must be paid before common stockholders
- Guaranteed income with potentially higher returns than traditional corporate bonds
- Typically less liquid than other bonds like treasuries and corporate bonds issued by larger companies
- Requires more advanced analysis of options and option pricing and deeper research abilities
- More complex than traditional bonds
- Interest rates are typically lower
When to Use Convertible Bonds In Your Portfolio
Convertible bonds are great for investors who want to generate income in retirement and enjoy more downside protection than investing directly in the stock market. When the stock market rises, convertible bonds will not typically rise as much, but they also offer more downside protection (if they are not trading well above par at the time of purchase).
Advanced Strategy #2 - Add Dividend Growth Stocks Into Your Portfolio
Not all stocks pay dividends, but many do. Dividends are simply the cash a company chooses to pay out to its shareholders. Many companies pay dividends from a share of the after-tax profits that the company is generating. Dividends are generally declared and distributed to shareholders on a regular basis (usually quarterly, but sometimes monthly). Some growing companies pay dividends and others do not.
Most companies that pay dividends are usually well established, with a profitable business and a regular history of profits so the fact that they are paying a dividend at all can be a positive signal of the quality of the business and their capital allocation policies.
Within the area of all dividend paying stocks, companies that have average or even below average current dividend yields, but are expected to grow their dividends consistently and at an attractive rate for many years to come are called dividend growth companies.
Dividend growth companies can be good for earning higher income and greater total returns for long-term investors. At Ridgewood Investments, we have an entire team dedicated to finding great dividend growth investing opportunities.
To implement our dividend growth strategy, we look for well established, profitable, secure and well-run companies that pay a dividend yield currently averaging around 3%, with positive annual dividend growth. The steady growth of the dividends helps to increase total returns and provides some long-term downside protection.
- Dividend stocks tend to be less volatile than many other types of stocks, reducing your portfolio risk
- Many companies, particularly “blue chip” or so-called “dividend aristocrats” stocks, steadily increase their dividends over time, which can help offset inflation and provide you a growing stream of income. If you start early enough this approach can provide a self-executing retirement income stream for you later
- Important to avoid companies whose dividend payout or dividend growth are unsustainable because that could create additional unnecessary risks to your portfolio
- Companies that pay dividends and have a long history of paying growing dividends sometimes have to reduce their payouts suddenly if the business starts to become challenged. It is critical to identify these situations as early as possible and reduce or eliminate them from your portfolio proactively
When to Use Dividend Growth Stocks
Dividend Growth Stocks are great for investors who want to generate growing streams of portfolio income and have a long-term time horizon to let the compounded effect of dividend growth companies work to really produce dividends (pun intended ).
Advanced Strategy #3 - Invest in Private Debt and Private Lending Opportunities
Private money lending involves lending money on negotiated terms to borrowers including real estate rehabbers and/or businesses. Typically the loans are made at interest rates between 6% and 15% often secured by valuable assets such as real estate.
Most private debt and lending opportunities have maturities from six months to three years though some can be longer.
One of main areas of opportunity within private debt are so-called “hard money” loans. They are generally short-term loans (most commonly 12 to 18 months) made to real estate investors, operators or developers who intend to buy property below fair market value with a plan to improve and sell the property within a defined period of time.
The reason that private lending opportunities at such attractive income rates exist is that the borrower typically needs to move quickly to take advantage of an attractive real estate investment or rehab opportunity. In these cases, banks usually cannot move quick enough to meet their needs and the opportunity has enough profitability to make sense for them despite the extra costs so they turn to private lenders at higher rates instead.
Pros and Cons of Private Debt Investing
- Passive participation as a lender secured by real estate collateral provides higher returns and significant downside protection
- Lender doesn’t have to manage the property or take any redevelopment risk
- Risk of borrower default, there is always the chance the investor won't honor the loan terms which can require foreclosure but usually returns the capital invested
- Even though the lender is generally secured by the real estate, taking legal action to recover interest can be an expensive and time-consuming hassle
- Hard to originate on your own as an individual investor - these opportunities typically are based on relationships and being an active lender in private debt markets
Ridgewood has significant experience in this area and we have helped our clients get access to attractive private debt and lending opportunities through our income private debt fund.
When to Consider Private Debt Investments
Private debt investments can be a good fit for you if greater diversification into a less volatile investment sounds interesting, a higher interest return than is available in bonds seems attractive, you like the downside protection of having a secured loan, and you don’t mind that private debt is an illiquid asset that you need to hold onto until maturity (generally less than two years). It can also be a fit for you if you have the right portfolio position sizing and having enough liquidity in other parts of your portfolio.
Advanced Income Strategy #4 - Income Generating Timberland and Farmland
Timberland investing means investing in ownership of land upon which trees are grown and harvested. The land itself has a value that tends to rise over time and it also generates a regular stream of income from the trees that are harvested each year. The timber industry has changed to become more environmentally conscious and sustainable though the demand for wood remains high and slightly increases over time.
Farmland is similar to timberland, except that crops are grown on the land instead of forests.
Pros and cons of Timberland and Farmland
- Biological growth automatically creates value over time - as trees grow in weight and density, they become more valuable on a per-ton basis. The income is literally grown and harvested and then distributed.
- Land Appreciation - land values tend to increase in the long-term especially if the timber acreage is located near growing areas. For example, if the forest land is located near a populated area that is expanding, the land could eventually rise in value at some point to be sold and then converted to another use such as commercial or residential development
- Steady growth in income yield helps to diversify a portfolio and acts as an inflation hedge
- Less exposed to stock market fluctuations due to the current income component and asset stability
- Exposure to fires can destroy the forestland or farm land (typically insured)
- Housing market or other economic downturns can temporarily reduce prices and lead to less demand for timber since timber and crop prices fluctuate based on a variety of factors including the economy and weather conditions
When to Consider Timberland and Farmland
You could use diversification that is not as correlated to the stock market and you want a monthly or quarterly income stream.
Advanced Income Strategy #5 - Consider Investing in Preferred Stocks for Extra Current Income
Preferred stocks (preferred securities) pay dividends to investors and are higher in priority than common stockholders of most companies. When people mention investing in the stock market, they are typically talking about common stocks and it is rare for investors to be aware of or know how to take advantage of opportunities in preferred stocks.
Preferred Stocks come in two varieties, convertible and non-convertible. For the former, see advanced strategy #1 - as convertible preferred stocks are a lot like convertible bonds but with less seniority.
Normal preferred stocks on the other hand are not convertible and they usually have a fixed dividend rate and a long-term redemption date (like 30 years) or can be perpetual. Many banks and utility companies issue preferred stocks because they get equity credit for these securities by their regulators.
While they have long maturities, most are also “callable” which means that the issuer can redeem them at a set price (generally par or a slight premium to par) well before their stated maturity date. They generally carry a credit rating from a recognized rating agency, and it tends to be a little lower than the issuing firm’s individual bond rating.
Preferred stocks like convertible bonds have many complexities and nuances so they are best used by someone who really understands how they work.
Pros and Cons of Preferred Stocks
- Liquidity - they can be bought and sold in securities markets - they are however less liquid than the common stocks of many companies
- Regular income distributions - generally quarterly and sometimes even monthly
- Seniority and better downside protection as compared with common stocks but lower than bonds
- Credit rating is generally lower than bonds
- Greater exposure to interest rate fluctuations due to their long maturity dates (or lack of maturity in the case of perpetuals). Thus, if interest rates rise, preferred stocks could trade at a lower price
- Dividends and distributions can sometimes be suspended. Some preferred stocks are cumulative while others are non-cumulative (cumulative is better)
When to Consider Preferred Stock Investments for your portfolio
A higher current distribution return seems attractive, you like the extra protection of having seniority to the common stock and you don’t mind that it is somewhat less liquid and you have thought about portfolio position sizing and having enough liquidity in other parts of your portfolio.
Advanced Income Strategy #6 - Consider Investing in Private Income Producing Commercial Real Estate
Most people think of the house that they live in (i.e. their primary residence) when they think of investing in real estate. Indeed for many people, the house that they own can be one of their biggest assets. Beyond their primary home, people sometimes consider investing in a small single unit property or perhaps a duplex or two.
However, investors investing in very small scale real estate - such as second homes, condos, and other small scale rentals often underestimate the work required, deferred costs, and forget to count the value of their time or vacancy expenses between rentals. After factoring in all these expenses, small scale houses or rental units can be challenging and have limited upside.
Still, what many don't realize is that there is another better way to participate in the income and growth that can be generated by solid income producing commercial real estate properties.
Commercial real estate investment done on a larger scale in partnership with other like-minded investors can generate worthwhile returns without any of the management hassles of small scale real estate holdings.
Ridgewood Investments has tremendous expertise helping select clients who want income from commercial real estate investments to add passive income into their portfolios.
Done correctly, Income producing commercial real estate can be very attractive by producing solid current income, growth and stability through ownership of buildings, often apartment complexes in growing areas of the United States. Commercial real estate investment offers very attractive tax advantages and savings that can even further increase the appeal of this source of passive income and growth.
Pros and cons of Commercial Real Estate
- Higher income than small scale residential real estate
- Stability, from long term secured leases for certain property types such as office and retail. Certain commercial leases include annual fixed rental increases or escalators
- Professional management can be hired to outsource time consuming tasks
- Commercial properties tend to appreciate at a greater rate than inflation
- Significant tax advantages generated by depreciation deductions and sometimes accelerated depreciation
- Real estate in general is subject to economic and political issues, unemployment, bureaucracy in opening business, etc
- Avoid investing in Private REITs or syndications with high distribution fees. These vehicles are often one of the worst ways to participate in real estate investments since they can pay up to 12% in marketing fees and commissions to the brokers who sell them. A 2014 report by Green Street Advisors, showed that privately held REITs under performed publicly traded REITs by about 3.6 percentage points per year in part due to their significantly high fees
- Dealing with K-1 forms that can require tax extensions to be filed
When to Consider Income Producing Commercial Real Estate for your portfolio
A higher current distribution return seems attractive, you like the security of having ownership in one or more tangible properties that can be professionally managed, you like the tax advantages, and you don’t mind that it is a less liquid investment and you have thought about portfolio position sizing and having enough liquidity in other parts of your portfolio, and you don’t mind getting a K-1 form for your income share at tax time.
Advanced Strategy #7 - Selling Options (Covered Call Writing)
Options are somewhat more advanced financial instruments that can be used to generate income in a portfolio in multiple ways.
Covered call writing involves selling someone else the right to buy a stock or other securities position from you.
This income strategy is best for those who intend to hold the underlying stock for a long time but do not expect an appreciable price increase in the near term. It serves as a short-term hedge on a long stock position allowing investors to earn income through the premium received for writing the option.
Many investors sell covered calls monthly, sometimes quarterly, to add several percentage points of cash income to their annual returns.
Calls sold are typically ”out of the money” which means that the option sold has a strike price higher than the market price of the underlying asset.
If the option gets exercised, the option writer must sell their stock at the strike price, which means a profit of the premium plus the difference between the strike price and the cost basis of the position. On the other hand, the option written can expire worthless and the option seller gets to keep the option premium they received upfront which adds to their income.
Over time, a covered call writing strategy will tend to generate a somewhat higher current income than the underlying stocks, a lower overall total return, but also a little less volatility than the market as a whole.
Pros and cons of selling options
- Complexity is high so risk of errors is also higher than many other areas for investment
- Options involve leveraging positions so the potential for gain and loss tends to be high
- Selling options is like offering insurance so there will be long-periods of steady low incremental returns and occasional large impact from securities getting called away
When To Use Options In Your Portfolio
Should only be used very carefully and only with expert assistance, since it is very easy to make costly mistakes or execute poorly.
Advanced Strategy #8 - Income Producing Real Assets like Infrastructure
Investing in infrastructure is a relatively new area of opportunity and a newer asset class but one that is worth serious investment consideration if done correctly.
Infrastructure assets include such areas as toll roads, bridges, ports, airports, electricity transmission lines, telecom infrastructure and pipelines to name just some of the major categories.
The need for infrastructure investments is high in both developed and developing countries, so the opportunity for growth in this category continues to be significant and untapped.
Infrastructure assets tend to throw off distributions to their investors, not unlike commercial real estate assets.
Pros and Cons of Investing in Infrastructure Assets for Income
- There is a global growing need for more infrastructure investment and it is a socially beneficial need as well
- Infrastructure offers uncorrelated returns and a diversification benefit
- Returns and income distributions are higher than bonds and are typically secured by valuable real assets which makes these assets less volatile than common stocks
- Infrastructure assets tend to generate more stable income streams because demand for these assets is either essential or even contractually guaranteed
- Capital assets have depreciation and therefore require continuous investment to keep facilities safe and in optimal shape
- Investment can be illiquid so you have to size them properly
- Assets typically purchased with significant amounts of debt (just like income producing commercial real estate) so you have to be selective and research opportunities carefully
When to Consider Income Producing Infrastructure Investments for Your Portfolio
A higher current distribution return seems attractive, you like the security of having ownership in one or more real infrastructure assets of some size with professional management, and you don’t mind that it is somewhat less liquid.
Summary and Next Steps
Now that we have reviewed each of our eight advanced passive income generating strategies for retirement income, it is time to review your own situation, preferences and needs.
It is safe to say that almost no one needs to actually use all eight strategies in their portfolio.
In fact, just implementing one or two of these income generating strategies can make a transformational difference to the amount of portfolio income, growth, and prosperity you set yourself up for in your retirement years.
Remember also, that each of the advanced strategies discussed involve complexity and require homework and judgement to utilize correctly and implement optimally.
To do all this well, you need to have time, read and research a great deal and become extremely knowledgeable in all these areas.
Very few advisors have the depth of experience that we have at Ridgewood Investments with exposure to all these areas and more. Our advisors have decades of high level experience and we can do the heavy lifting for you.
With very little extra effort other than that needed to schedule a conversation and speak with a Ridgewood advisor, we can help you to understand and select the retirement income and passive income generation options that will make the most sense for you and your portfolio.
If you are ready to start improving your portfolio, set up a conversation with Ken Majmudar, our founder, to go over the options and provide valuable counsel that can help you choose what may be right for you.
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For more on how Financial Advisors like our team at Ridgewood Investments are positioning their clients for success, check out my article: "How Great Advisors Are Positioning Clients to Survive and Thrive Through this Crisis".
About the Author
Kaushal “Ken” Majmudar, CFA founded Ridgewood Investments in 2002 and serves as our Chief Investment Officer with primary focus on managing our Value Investing based strategies. Ken graduated with honors from the Harvard Law School in 1994 after being an honors graduate of Columbia University in 1991 with a bachelor’s degree in Computer Science. Prior to founding Ridgewood Investments in late 2002, Ken worked for seven years on Wall Street as an investment banker at Merrill Lynch and Lehman Brothers where he has extensive experience working on initial public offerings, mergers and acquisitions transactions and other corporate finance advisory work for Fortune 1000 companies. He is admitted to the bar in New York and New Jersey though retired from the practice of law.
Ken’s high level experience and work with clients has been recognized and cited on multiple occasions. He is a noted value investor who has written and spoken extensively on the subject of value investing and intelligent investing. He has been a member of the Value Investors Club – an online members-only group for skilled value investors founded by Joel Greenblatt, SumZero – an online community for professional investors, and has also written for SeekingAlpha – among others. Ken is active in leading professional groups for investment managers as a member of both the CFA Institute and the New York Society of Securities Analysts.