By reinvesting the returns on dividends shares until retirement, investors can work towards a steady second income.
The regular payments that these stocks payout make them highly attractive for compounding returns. Using a dividend reinvestment plan (DRIP), the payments return to the pot. Over time, these small contributions can lead to exponential growth!
Plus, with a Stocks and Shares ISA, UK residents can invest up to £20,000 a year without paying any tax on the capital gains.
Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.
Choosing the right shares
Ideally, I’m looking for shares with a long track record of dividend growth. There are quite a few FTSE 100 shares that fit that criteria.
A couple of examples off the top of my head are British American Tobacco and Diageo. Both are trusty components of my dividend income portfolio.
These stocks become known as Dividend Aristocrats by developing a reputation of consistently increasing dividends. Once they achieve such an honour, they hesitate to lose it, so they do whatever is possible to keep their streak going!
A dividend hero
I recently added the utility group Severn Trent (LSE: SVT) to my retirement income portfolio. Barring two minor reductions, it’s been increasing its dividend consistently for over 20 years at an average rate of 3.8% per year.
Like fellow utilities group National Grid, its services are likely to remain in high demand. That makes it defensive against market dips, which is reflected in the fairly stable share price.
It has a LOT of debt though, which is a risk. If it can’t reduce this soon, it could default on payments and run into financial trouble.
The past year has been a struggle, with the share price down 2%. But revenue, income and profit margin all increased as of its latest earnings call, so things are looking up. Plus, it managed to raise its dividend which is the key thing I’m looking for.
The yield now stands at a moderate but sustainable 4.5%.
Yield considerations
Buying the top 10 highest-yielding dividend shares seems like the obvious choice, right? Wrong.
The yield alone doesn’t tell me much about the stock’s reliability. Yields can change rapidly and dividends can be cut or reduced at any moment.
For example, at 4.8%, the City of London Investment Trust has a smaller yield than many. However, it has 58 years of consecutive dividend growth under its belt. That’s why I believe it makes an excellent addition to my dividend portfolio.
I also carefully select some high-yielding but reliable stocks, like Legal & General. It’s currently trading below fair value which means the yield has increased to 8.7%, making it attractive.
Estimating the returns
With a mix of yields between 4% and 10%, it’s possible to achieve an average yield of 7%. One could also estimate a further 3% to 4% returns from price appreciation.
£10,000 invested into a portfolio with those averages could grow to around £183,500 in 30 years. It would pay around £12,000 in dividends each year.
That’s not bad. But adding a further £100 each month could balloon it to £388,000. That would pay annual dividends of £25,000 — over £2,000 a month.
Now that would be a decent addition to a pension.
