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Forget the State Pension! I’d generate a passive income from FTSE 100 dividend stocks

For many people, generating a second income in retirement is a necessity. The State Pension of £8,767 per year is a useful income in older age, but is simply inadequate in terms of being able to fully provide financial freedom for retirees.

Deciding from where a second income should be generated can be a tough process. Assets such as bonds, property and even cash have proved popular in the past. However, at the present time, FTSE 100 dividend stocks could be the best place to start as they offer a high income return as well as the potential to beat inflation over the long run.

Returns

Perhaps the biggest challenge facing investors who are looking to generate a passive income is the lack of return potential available from mainstream assets. Cash ISAs, for example, have an interest rate of around 1.5% at the present time. This is below the rate of inflation, and equates to reduced spending power in the long run.

It’s a similar story with bonds. A 10-year UK government gilt has a yield of around 1.1% at the present time. It means that an investor would need to have a significant amount of capital available just to generate a modest second income. Certainly, a number of corporate bonds have much higher yields than 10-year gilts. But their risk generally increases as their yields rise, while bond prices in general may suffer from a rise in interest rates over the medium term.

Property yields continue to be high in some parts of the country. It is still possible to generate a second income from buy-to-let investments. However, doing so is becoming increasingly difficult, with tax changes and the prospect of higher interest rates potentially leading to pressure on landlords’ cash flow over the coming years.

By contrast, it is possible to generate a 4%+ net income return simply from buying a FTSE 100 tracker fund. A number of FTSE 100 stocks offer significantly higher yields, which means that from a return perspective, the stock market could offer the best solution to the inadequate State Pension.

Risks

Clearly, investing in shares is riskier than holding gilts or investment-grade government bonds. Property may also be viewed as more stable than shares, while cash savings do not put capital at risk.

However, the FTSE 100 still appears to offer good value for money even after its rise during the course of 2019. This could mean that investors are able to buy a variety of stocks that have margins of safety, which may reduce their overall risk profile. The index also has a track record of delivering long-term growth, with it having recovered from every bear market it has faced in the past.

With bonds set to be negatively impacted by rising interest rates, buy-to-let investing becoming increasingly complex and cash savings offering a negative real-terms return, FTSE 100 dividend stocks could prove to be the best means of generating a passive income from a risk/reward perspective.

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Peter Stephens has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.