Building a passive income stream to supplement my own efforts at earning money seems like a brilliant idea to me, and I’m doing it by investing in FTSE 100 shares.
Blue-chip UK stocks are a great way of producing a second income stream, because they pay some of the most generous dividends in the world. Incredibly, around a dozen now yield more than 7% a year, beating every savings account, with capital growth on top if their share prices rise.
I’m looking to the future
If I had no savings at 40, aside from some cash in an easy-access account for emergencies, I’d begin my hunt for passive income on the FTSE 100.
Personally, I’d buy individual company stocks, because that way I can generate a higher yield than, say, purchasing a tracker fund that invests in the entire index.
If I didn’t feel confident enough to buy stocks, I’d consider buying the actively managed City of London Investment Trust, which targets UK equity income stocks and currently yields more than a Footsie tracker at 4.84% with an ongoing charge of 0.45% a year.
But for me, it would be direct equities. Right now, I feel spoilt for choice, because a host of big name FTSE 100 dividend heroes are offering super-sized yields while trading at dirt cheap valuations.
Aviva, for example, currently yields 7.59% a year. Housebuilder Taylor Wimpey yields 7.52% and is valued at 6.6 times earnings (15 times is seen as fair value).
British American Tobacco yields 7.77% and trades at 7.5 times earnings. I’d reinvest all my dividends for growth while working, with the intention of drawing them later as income.
So at 40, how can I invest enough to generate a passive income of £5,000 a year by, say, 65? Under a financial rule of thumb known as the ‘safe withdrawal rate’, I should aim to take 4% of my portfolio each year as income. By doing that, my capital should never deplete.
Generating income from shares
Using that rule, I’d need a portfolio worth £125,000. The good news is that at 40, I’ve got 25 years to get there.
Now let’s assume that my portfolio delivers an average annual total return of 6.89%, in line with the FTSE 100 performance over the last 20 years. If I invested £1,500 a year, which is £125 a month, and increased my contribution by 3% in year, I’d have £131,725 by age 65. That’s an income of £5,269 a year, or £439 a month.
That’s pretty good going given that my initial stake was just £125 a month. It shows the compounding impact of shares over time.
Naturally, there are risks. My chosen stock picks could underperform or in extreme cases, even go bust. They could cut their dividends. Future share price returns generally may be lower or the market could crash at the wrong time. I also have to take the impact of inflation into account.
But the earlier I start saving, and the more I pay into my portfolio, the better my chances of hitting or exceeding my income target. If I had no savings whatsoever at 40, I wouldn’t waste any time.
