For investors wanting to build up some long-term passive income, we have a couple of formidable tools at our disposal. They’re the Stocks and Shares ISA and the Self-Invested Personal Pension (SIPP). Both offer tax benefits, and can be used in combination depending on individual goals.
Saving tax isn’t much good if the investment performance is poor, like the puny long-term returns from Cash ISAs. They can be great for short-term cash — but as long-term passive income vehicles, I rule them out of my plans.
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.
I do think we need to take some risk. And for me that risk comes in the form of shares on the UK stock market.
How risky?
Barclays used to publish a free annual study looking at past returns of UK stocks, cash and gilts. It showed UK shares have beaten other forms of investment hands down for more than a century.
Over short periods, cash turned out better — the 2020 stock market crash is an example. But the longer the study extended its rolling periods, the more a pattern of stocks outperformance emerged. Over 18-year periods, stocks didn’t lose out to cash even once.
Got a 20-year investing horizon? That’s long enough for me to think the diminishing risk of stocks and shares is worth taking.
How might we get to £3,000 a month, or £36,000 a year? Over the past 20 years, FTSE 100 total returns have averaged 6.9% a year. If that continues, we’d need a pot of around £520,000.
Some years will provide better returns, some years poorer returns. But we can vary the amount of dividends we take and shares we sell to try to even it out.
Buy the index?
Investing in an index tracker fund, like the iShares Core FTSE 100 UCITS ETF (LSE: ISF) is a popular way to spread the risk through diversification. It has a long name, but that belies its simplicity. It invests in a range of stocks to aim to reproduce the FTSE 100 performance, and it gets pretty close.
If we knock 0.1% off the annual return to allow for management charges, how soon could we reach the half a million pounds we’re aiming for?
If we can invest the full £20,000 annual ISA allowance each year, we could get there in about 15 or 16 years. The power of compounding really can turn total investments of £300,000 into more than £500,000. But if we can keep going longer, it gets better.
Continuing for just another five years, we could hit a storming £830,000. And that could smash through our target income and hit £4,700 a month.
Of course, with less money to invest it will take longer, sometimes a lot longer, so starting early is always a good thing.
Would I put all my money in the iShares Core FTSE 100 fund? It’s still a single investment managed by a single company. And that adds a bit more risk on top of the general stock market risk — we already need to allow for something like that 2020 crash, remember.
I’d build on it with other trackers, investment trusts, and individual shares. But the (not so secret) secret is to invest as much as we can, for as long as we can.
