No matter how much or little we enjoy working, the prospect of a leisurely retirement has its appeal. But it costs money and it is only likely to get more expensive as the years go by. I think setting up passive income streams could help me retire early. Here is how.
1. Start saving — today
A critical point is that it is never too early to begin planning for retirement, even if it seems far in the future.
The core of my passive income plan is investing in dividend paying shares and then reinvesting the dividends. To do that, I would put aside a regular amount each month during my working life. The more I put in today, the bigger the benefits will be in the long term.
For example, if I invest £250 a month in shares with an average dividend yield of 5% and reinvest the dividends, after 25 years I should have over £155,000 worth of shares. That would produce annual passive income of around £7,800.
But if I follow exactly the same approach with only £200 a month – just £50 a month less – it would take me a further four years to reach the same amount. This example presumes constant dividends and share prices, which are unlikely in practice across such a long period, but the principle is still important to understand. Pushing myself to invest more into a passive income plan now would help speed up my returns faster than waiting until retirement approaches to boost my contributions.
2. Buy dividend shares
The next step is finding the right dividend shares to buy for my own objectives. To do that, I would look for businesses I understood that I thought had good long-term prospects. I look for prospects based on customer demand continuing to exist and the company having a competitive advantage in that market.
For example, I think the beer market will still be here in decades and Diageo owning the Guinness brand gives it a competitive advantage. I think power distribution will still be needed for decades, and the network of National Grid is hard for a competitor to try and copy.
But the amount of dividends I receive does not depend purely on how well the business does. It is also determined by the price at which I buy the shares. For example, the Diageo dividend yield stands at 1.9%. But its share price has risen by 20% over the past 12 months. So if I had bought a year ago, I would now be receiving a yield close to 2.3% on my Diageo investment.
3. Reinvest the dividends
A lot of people set up passive income plans as a way to generate some extra pocket money while they work. But if my focus is on bringing forward my retirement, I would design my plan specifically to meet that objective. So I would reinvest the dividends while I worked, and then only start to draw the passive income once I retired. By doing that, I could hopefully meet a monthly passive income target for earlier retirement.
The example above already shows how investing more money early in the plan can have big benefits down the line. Part of the reason for that is what is known as compounding. That may sound boring but it is crucial to understand if you are serious about retiring early.
The playground game of trying to fold a piece of paper and then keep folding it is a simple way to understand compounding. Basically, each move gets progressively harder because there is more and more paper to fold. Hopefully, compounding dividends works in a similar way.
Right now, for example, the yield on Direct Line is 9.7%. So if I invest £1,000 in its shares today, hopefully at the end of a year, I would have £1,097. If I reinvest that extra £97 in Direct Line shares, the following year I should receive dividends on £1,097 worth of shares not just £1,000.
Over the years, this compounding effect can be huge. For the Direct Line example, after 25 years my £1,000 today should be worth over £11,100. Only £1,000 of that is what I invested – the rest would have come from compounding the dividends.
4. Diversifying my passive income streams
Again, this example presumes a constant share price and dividend. That might not happen. Direct Line could see resilient demand and boost its dividend, as it did last year. Then again, it may run into a business problem like bad storms pushing up claims costs and cut its dividend.
So that is why I would diversify my passive income portfolio over a range of companies and different industries. Taking a view across decades towards retirement, even the best run businesses could face serious challenges. Making sure any one share only produces a limited amount of my overall passive income streams can help me cushion the impact on my earnings if a business does badly.
5. The value of patience
The fifth and final step of the plan is sitting back and letting time work its magic. I would keep putting money aside regularly and compounding dividends. But the long-term impact of compounding only really becomes evident over time.
A lot of people are impatient and want to keep trading in and out of shares, incurring fees. But I see that as a trading rather than investment mindset. A serious approach to retiring early with a certain amount of passive income benefits from a long-term investment mindset.
If I find the right companies to invest in, for the most part I would expect to own their shares for years or even decades. Rather than trade frequently, I would mostly just sit back and hopefully watch my future passive income streams continue to grow.
