Passive income is the perfect way to continue receiving an income after retirement. My pension will only stretch so far, so if I want to retire early, I’ll need something extra.
I think the best way to do this is with a portfolio of shares that pay dividends.
How dividends work
A dividend is like a small gift that companies pay their shareholders every year as a thank-you for investing in them. A 5% dividend yield on a £1 share would pay me 5p for each share I hold. This is in addition to any returns made if the share price increases.
Dividends on shares are calculated annually, although often paid in two or four payments a year. Subsequently, my plan would involve building a portfolio of dividend shares that pay approximately £12,000 a year.
Once the passive income stream has been established, I can begin withdrawing my returns as needed.
Dividend yields change regularly, so it’s impossible to know how much I’ll receive each year. But with a portfolio of well-selected stocks, I can aim for a conservative average of around 5%.
How my strategy could work
I’ll use the small-cap iron casting and machinery firm Castings (LSE:CGS) as an example.
Its 5% dividend yield is lower than many other UK stocks but it has an excellent track record of making regular payments. I’d aim for a good mix of reliable low-yield dividend shares and less reliable high-yield shares.
Furthermore, it’s currently estimated to be trading at 58% below fair value so could go up from here. I don’t want to dive into an overvalued dividend stock that could lose value and negate any returns I make from dividends.
On the downside, Castings earnings are forecast to grow at only 3.1%, slower than the UK average of 12.6%. Still, the dividend payments make it worthwhile.
I’ve calculated that I could reach my goal of £1,000 a month in passive income in 20 years with the following strategy.
My outcome is based on a 5% dividend yield with semi-annual payments and an expected 0.2% annual dividend increase. I’ve also calculated an expected 6% annual share price increase. This is based on the past performance of an average basket of well-performing FTSE stocks.
- First, I’d invest £12,000 into a portfolio of shares similar to Castings
- I’d use a dividend reinvestment plan (DRIP) to put any dividends earned back into the investment
- I’d contribute an additional £200 a month to the investment
In 20 years, my investment could have grown to £257,395. At this point, my average annual returns with dividend payments could be £12,081 – just over £1,000 a month.
Risks
There are risks involved with such a strategy. I can’t guarantee the dividend payments will be consistent, or remain at 5%. The share price of any stocks I include could also fall, resulting in financial losses.
For this reason, I need to carefully research all the stocks I add to my portfolio. I should ensure they have a solid history of growth potential and a track record of making reliable dividend payments.
