Routes to passive income: How to create a large asset base that can generate income for a long time

Financial freedom means generating passive income. Thus runs a popular personal finance rule. Makes sense, right? If you can earn an income without having to work for it, that is the best place to be. In the traditional sense, income from dividends, interest and rent were the most sought after passive incomes. The hawk-eyed protection of capital was driven by the need to have an undiminished amount of capital generating interest income. In the days of high and rising interest rates that made some sense.

Then the smarter investors began discovering the dividend yield. The 1970s saw the first dilution and stake sale of many large multinationals. These stocks belonged to well known names like Unilever, Pfizer, Glaxo, Colgate and Nestle, respected for their quality products. Restrictions imposed on them at that time stopped them from expanding their business, or repatriating their profits to their home countries. These businesses thus were generous dividend payers. Many retail investors chose them for passive income.

The increase in home ownership created rental yield as the next choice of passive income. As Indians began working abroad and earning higher incomes that they repatriated back home, it became common for elderly parents living in India to have a second house, located nearby or on the same plot as their home. The tenants offered much-needed support as well as passive rental income.

In the early 2000s these traditional routes to passive income lost their sheen. With the fall in inflation, interest rates dropped; and there were fewer and fewer “safe” choices for earning interest income. Many senior citizens were duped by unscrupulous deposit mobilising organisations that promised high interest but vanished with the principal.

Stock markets turned their attention to growth over dividend distribution. The top performing businesses that made investors the money were not paying dividends, but expanding in their chosen business. Capital gains far exceeded dividends as a source of income from equity. Mutual funds which were earlier forced to distribute their income as dividends now offered a growth option that enabled the money to grow. PSU stocks that had replaced MNCs as high dividend payers also began to slip in performance.

The housing market meanwhile took off with the availability of cheap credit. Even as income earners were taking home loans with their salary slips as proof of their ability to pay EMI, the cash earners and unscrupulous elements took over the market. Property prices skyrocketed and rental yields plunged. Worse, unsold housing stocks in most metros depressed rental yields even further.

But the markets for passive incomes have only just begun to bloom and grow spectacularly. Ask the creators of content on YouTube and the publishers of books on Amazon and they will have many stories to tell. The ability to earn for pages, views and through tie ups with product manufacturers has led to a deluge of content. Housewives and grannies have been woken up to come and make some money, showing the world how traditional food is made in their households. A long genre of topics, from home improvement to photography, travel and tourism to adventure sport, films, art, music and a million other things are now produced and published as videos. They earn a steady source of income for the content creators.

The market for commissions has long changed from a fixed fee for a product on being sold. Distributors of mutual fund products have been earning a passive income called the trail commission. This is paid on the value of the investment, as long as the investor stays invested in the fund. As the fund grows in value, the distributor that sold the product earns a passive income on it. Many distributors have built a large enough corpus to earn adequate passive incomes from the money they helped mobilise and stay put.

The path to financial freedom has been defined by many job roles by reworking the salary package to include ESOPs and other forms of variable pay. These are not passive incomes in a strict sense. But they represent gains an individual can make by choosing to link income to the performance of the stock of the firm they work for. Wealth studies across the world show how such stock ownership has created the largest chunk of the newly wealthy class. The risk of owning equity, especially concentrated holding in the firm one works for, has been rewarded with substantial payouts for many employees. The large corpus thus created is adequate to fund a new business, take an early retirement, or be invested to generate income over a long future.

Royalties and periodic payouts have now become the norm for artists, musicians and several other creative talents who contribute to the commercial success of an advertisement, a movie, a television serial, a concert, a show or any commercial venture that uses creative inputs. Actors have moved to seeking a share in profit rather than a fixed remuneration. Many large earners to smaller bit players are now content to earn a variable income. This shift also marks the overall confidence in the success of ventures and the newfound ability and willingness to take risks. Everyone is keen to ensure that their income enjoys the scope to be enhanced in any manner possible.

There was a time when a key personal finance goal would be defined as steady and stable income. Today that definition requires modification. It is the creation of a large value asset that can be used over a long period of time; or a large corpus from a payout adequate to fund one’s future comfortably; or a variable income that increases from changes in the value of service or product in the marketplace. People have found various ways to build assets and earn from them; or enhance the value of content a human asset can produce. They also confidently negotiate fair prices for that value and accept risks and variability.

Investing still remains a vital function for deploying and managing wealth. Poor investment decisions can ruin the structures we just discussed and assets can be eroded, lost or diminished in value. Tragic stories of poverty among sellers of agricultural land for fancy prices abound. But that is for another week. Celebration of innovations in earning incomes is all we shall do this time.

(The writer is Chairperson, Centre for Investment Education and Learning)