The idea of getting a regular, tax-free income without going to work might sound like a pipe dream, but this is exactly what a carefully constructed portfolio of investments can deliver.
But what does it take to generate an income of £12,000 a year?
So-called income funds do not aim to shoot the lights out with growth – where your capital increases each year – but instead try to pay a regular and reliable sum to their investors.
This might come from dividends paid by companies the fund invests in or from interest paid on bonds it holds.
There are plenty of reasons to choose an income fund but they are particularly valuable to retirees looking for a reliable flow of money.
Invest through an Isa and you won’t even need to pay tax on it as all dividends and capital gains are tax-free.
For the long-term: So-called income funds try to pay a regular and reliable sum to their investors
Rob Morgan, chief investment analyst at Charles Stanley Direct, says: ‘Income investing is all about regular and sustainable cash flow. In retirement, it can help fund your lifestyle and, for someone still working, it can act as a supplement or help cover expenses through difficult patches.’
While it’s possible to choose your own dividend-paying stocks or bonds, using a fund is easier. This way an expert manager can pick the best investments and spread your money across different holdings, helping to reduce your risk.
Hal Cook, senior investment analyst at Hargreaves Lansdown, says: ‘Because funds invest in lots of underlying assets, investors aren’t impacted as much if, for example, one company cuts its dividend or defaults on its bond payment.
‘The idea is the remaining investments can make up for any shortfalls, and you have an expert manager looking after the day-to-day decision making.’
The table below shows how you could generate an income of £12,000 tax-free using the funds mentioned above. We’ve assumed a total of £258,000 is split evenly between the ten funds to give an example of how this would work.
You will want to pick funds that meet your own needs and may want to put more in some than others.
How to invest for income
When choosing a fund, you will typically be given two options: accumulation or income units. Choose income.
Accumulation units automatically reinvest income, which is a great way to boost returns, but not suitable for those who want the pay out. Income is usually paid twice a year but some funds pay monthly.
Diversification (not putting all your eggs in one basket) is important. Choose a mixture of funds, including those investing in stocks, bonds and other assets such as property and infrastructure.
‘This will help balance the ups and downs of the stock market and smooth your overall returns,’ says Morgan.
The amount of income paid is known as the fund’s yield. This is essentially how much you can expect to receive based on how much you have invested, expressed as a percentage. If you invested £1,000 in a fund yielding 4 per cent, you could expect £40 a year. But this is not guaranteed and can fluctuate.
Generating £12,000 a year will require a significant amount of capital, says Darius McDermott, managing director at FundCalibre.
It may be tempting to focus on the highest-yielding funds but these will tend to be riskier. This is because firms they invest in may pay a higher income to compensate their investors when, for example, there is a greater risk they may not get all their money back. ‘Don’t chase high income at any cost,’ he warns.
Should you pick a fund that does it all?
Multi-asset funds invest across a range of areas, ensuring your income comes from a variety of sources. This is important because income is never guaranteed – firms can cancel dividends and bonds can default (meaning they don’t pay the interest you are due).
Cook likes the Baillie Gifford Monthly Income fund, which aims to grow its income by more than inflation.
Some 30 per cent of its portfolio is in shares of firms such as Apple and Taiwan Semiconductor, 20 per cent in infrastructure such as wind turbines and it also holds government bonds such as UK Gilts and US Treasuries.
‘Its mix of investments means the fund doesn’t rely on just a single type of asset to generate income,’ says Cook. The fund yields 4.1 per cent.
Morgan suggests Ninety One Diversified Income as a good anchor for an income portfolio, providing ‘a steady sustainable income with less volatility’.
It has 60 per cent of its portfolio in bonds and invests in shares including PepsiCo, Rio Tinto and Morgan Stanley. It yields 5 per cent.
How to find a dividend fund that delivers
Many companies return some of their profits to shareholders through dividends and these firms can be a good way to generate income.
Morgan likes the M&G Global Dividend fund, which invests across the UK, US, Taiwan and more. Its biggest holdings include Imperial Brands, Carlsberg and the Canadian oil and gas company Keyera. The fund yields 3.1 per cent.
He also likes Trojan Global Income, adding: ‘This is a more defensive fund, investing in resilient businesses, well-placed to grow their earnings and dividends regardless of the economic cycle.’
The fund, which invests in the insurer Admiral, the railway network Canadian National and pest firm Rentokil Initial, yields 3 pc.
Investment trusts can be a great hunting ground for income seekers. Trusts can hold back some of their profits in reserve from good years, so they don’t have to cut their income in leaner years, which makes them reliable income payers.
Some trusts have increased their payout for at least 20 years in a row.
McDermott likes the City of London investment trust for a well established option run by an experienced manager. It yields 3.73 per cent and has raised its dividend for 59 consecutive years.
What about investing in bonds?
A bond is an IOU issued by a company or government, which borrows money from investors for an agreed period to fund its spending. In return, it pays a regular amount of interest (coupon) for the length of the bond and your original money back at the end.
Some bond funds stick to a certain type of debt. For example, that issued by governments or by robust firms that are unlikely to miss a payment.
High-yield bond funds pay a higher income because they focus on companies with lower credit ratings, which may be more likely to default.
Cook likes Artemis High Income, a strategic bond fund which invests in a mixture: from German, UK and US government bonds to those issued by the likes of Barclays and Tesco. It yields 5.58 per cent.
McDermott likes the Jupiter Monthly Income bond, which yields a meaty 6.21 per cent without taking too much risk. It holds bonds from Marks & Spencer, HSBC and Royal Bank of Canada.
Don’t forget property and infrastructure
Infrastructure funds can offer inflation-linked income because they have long-term contracts with companies and governments, which means your payout keeps up with the cost of living.
These funds invest in assets such as railways, adding an extra element of diversification.
Morgan likes International Public Partnerships, which owns schools, hospitals and renewable energy projects, mostly in the UK. It yields 6.7 per cent.
McDermott likes the TR Property Investment Trust which owns offices, hotels, student accommodation, retail and industrial units across the UK and Europe. It generates an income from the rent it receives, and yields 4.5 per cent.
Or just keep your fees low
If low fees are a priority, consider a tracker fund. The iShares UK Dividend exchange-traded fund (ETF) tracks 50 dividend-paying firms from the FTSE 350, with low annual fees of about 0.4 per cent.
The UK stock market is a good stomping ground for income seekers, with a host of reliable dividend payers, such as Legal & General and BP. The fund yields 4.7 per cent.
