If I had £250,000 spare, how would I use it to generate a lifelong second income? A friend recently asked me this question, because she will receive a windfall of this size this year. My answer was that I would invest it in dividend-paying shares for income and long-term gains. But what would she prefer?
Building a second income
My friend has many options to generate passive income from her capital. She could take zero risk by depositing this money in a savings account and spending the interest. But she’s willing to take on risk to boost her long-term returns.
Perhaps she could invest her pot in government and corporate bonds? These IOUs issued by governments and companies pay regular interest (coupons) to bondholders. For example, a 10-year UK Gilt pays 3.4% a year. However, my friend isn’t keen on bonds, because rising interest rates reduce bond prices.
Another alternative would be to purchase a buy-to-let property (outright or with a mortgage) to let out to tenants. But with house prices weakening and mortgage rates rising, my friend doesn’t fancy this risk. She also isn’t keen on maintaining another property on top of her family home. And rental yields are modest in her area (under 5% before costs).
My friend can afford to take risks
As a career woman, my friend is a lifelong member of a guaranteed/final-salary/defined-benefit pension. This payout from her employer would cover her usual monthly expenses, with some to spare. This leaves her in a comfortable and fortunate position for her retirement.
Therefore, given my friend already has one index-linked retirement income for life, she believes that she can afford to take on the risks of share ownership. Also, she refuses to buy an annuity with her lump sum. (An annuity is a lifetime income paid by an insurance company to a recipient, who surrenders a lump sum in return for regular payouts.)
I’d invest a windfall in dividend shares
In addition, my friend would like some freedom and flexibility with her investments, such that she can leave them to her children in her estate. Hence, my advice to her was to build a well-diversified portfolio of, say, 20 dividend-paying shares in quality companies. As for me, I’d buy various high-yielding FTSE 100 and FTSE 250 shares. And that’s exactly what I’ve been doing over the past seven months.
Also, I gave one vital caution to my friend: I warned her about ‘sequence of returns’ risk. What this means is that the order, timing and size of her returns will have a major impact on how long her windfall lasts. For example, if she took out a fixed 10% of her pot (£25,000) each year, she runs a real risk of depleting her fund.
My suggestion, based on established actuarial research, is to take a variable 4% a year from her pot. Initially, this comes to £10,000 in year one. Now let’s say her pot has grown to £350,000 after 10 years. She can then take out £14,000 that year. And so on until her death.
Finally, I’ve urged my friend see a highly qualified, fee-charging investment consultant to understand these various options. And I’ve warned her to steer well clear of financial products with high commissions and/or confusing structures!
