For many of us, the dream is to have enough money invested by the time we retire that we can sit back and earn enough in dividend income each month to pay the bills without having to touch our capital or dip into our state pension.

However, with many companies which used to pay big dividends, such as energy giants BP (BP.) and Shell (SHEL), having ‘rebased’ their pay-outs at lower levels, what are the options for investors today?

Shares looks at what it costs to enjoy a ‘moderate’ lifestyle without taking excessive risks with your investments.

THE RISING COST OF LIVING

According to a recent report by the PLSA (Pensions and Lifetime Saving Association), those in or heading for retirement have seen their spending rise by almost 20% over the last year due to the rapid rise in inflation across UK goods and services.

Based on research by Loughborough University’s Centre for Research in Social Policy, the PLSA’s report on retirement living standards calculates how much the average person now needs to live a ‘minimum’, ‘moderate’ or ‘comfortable’ lifestyle.

After tax, the annual cost of a ‘minimum’ lifestyle is estimated at £12,800 for an individual and £19,900 for a couple.

For a couple, that figure is more than covered by the new full state pension, which increases to £10,600 in April thanks to the triple lock, while the PLSA believes £12,800 for a single person is ‘very achievable if they supplement the state pension with income from a workplace pension saved through automatic enrolment during their working life’.

For the record, the PLSA’s minimum retirement living standard is the same as the Joseph Rowntree Foundation’s minimum income standard and reflects what members of the public think is required to cover a retiree’s needs, not just to survive but ‘to live with dignity, including social and cultural participation’.

It includes £96 for a couple’s weekly food shop, a week’s holiday in the UK, eating out about once a month and some affordable leisure activities about twice a week, but doesn’t include a budget to run a car.

A ‘moderate’ lifestyle costs an estimated £23,300 for a single retiree and £34,000 for a couple and provides ‘more financial flexibility and security’.

It allows for a £127 weekly food shop for a couple, a two-week holiday in Europe, eating out a few times a month and a three-year old car which is replaced every 10 years.

To live a ‘comfortable’ lifestyle with more financial freedom and room for a few luxuries like a three-week holiday in Europe and up to £1,500 to spend on clothing and footwear every year would cost £37,300 for a single person and £54,500 for a couple.

MAKING THE NUMBERS WORK

For our base case, we have taken a single person entering retirement this year and expecting to get the full state pension of £883 per month or £10,600 per year (the amount paid from this April) which they aim to supplement from a £200,000 private pension ‘pot’, assuming they have already withdrawn their tax-free 25% lump sum.

In order to top up their state pension of £883 to £1,500 of post-tax income per month, or £18,000 per year, they can generate £1,970 of income to take them to the annual personal allowance threshold of £12,570, but after that they have to pay 20% tax on any income generated.

In other words, to get to £1,500 per month they need to generate £730 of additional income. 

On an annual basis, to reach the target £18,000 after tax requires £8,758 of additional income, which based on a ‘pot’ of £200,000 equates to a pre-tax yield of 4.4%.

Obviously, the higher the desired level of income, the higher the pre-tax yield needed to generate the uplift, so for a single person wanting to have £1,666 post-tax per month (or £20,000 per year) the required yield increases to 5.5% based on the same ‘pot’ of £200,000, while £1,916 post-tax per month (£23,000 per year) implies a yield of 7.4% which is more of a stretch.

Similarly, if the ‘pot’ is significantly smaller than £200,000, the yield needed to achieve the desired level of post-tax income also increases, but at an even sharper rate.

PUTTING IT INTO PRACTICE

One straightforward option for generating monthly income is to invest in funds or investment trusts which pay dividends monthly rather than quarterly.

Monthly income funds hold onto the dividend and coupon payments they get from the stocks and bonds they own and pay it out to investors as a steady stream.

Typically, a fund will make 11 equal payments as it smooths out its own income followed by a final payment, which is everything left over, although some funds pay out whatever income they received in the prior month, which means payments can be erratic, and yields can vary a lot.

Investment trust TwentyFour Select Monthly Income (SMIF), managed by the UK ‘boutique’ bank subsidiary of Swiss-based Vontobel, invests in a diversified portfolio of fixed-income securities to pay out regular monthly distributions.

As the managers point out, not all their investments are liquid, so they are paid an ‘illiquidity premium’ or a higher-than-normal yield for owning them, which they believe is attractive on a risk-adjusted basis.

Most of the trust’s holdings are in asset-backed securities or bank debt, the majority of which is issued in the UK and Europe, with a credit rating of B or better and a maturity of between three and seven years.

The biggest holding as of the end of last year, representing just over 3% of total assets, was a 10.25% perpetual loan note issued by the Nationwide building society which is rated A1 or A+ by the major credit rating agencies.

With an 8.1% yield, minus an OCF (ongoing charge figure) of 1.15%, the trust more than meets the basic criteria for our retirees, both single and married, but no-one should invest all their savings in one fund, so we need to cast our net wider to find additional sources of monthly income and spread the risk.

As its name suggests, the Aberdeen Standard Select Emerging Markets Bond Fund (BYZC5X6) invests in a variety of company, government and other bonds in emerging markets and distributes income monthly in sterling.

Over 80% of its assets are denominated in dollars, so the fund is hedged which incurs a cost, meaning it has quite a high OCF of 1.75%, although at the end of 2022 the yield to maturity on the portfolio was 11% so again the fund fits our basic criteria albeit with more risk.

The Artemis Monthly Distribution Fund (B6TK3R0) typically invests globally, 60% in bonds and 40% in equities, with the managers aiming to generate a yield of 4% or thereabouts.

The fund currently yields 4.8%, and although the OCF is 0.86% meaning the net yield is less than 4% there is a case to be made for including it as part of a blended portfolio.

BUILD YOUR OWN INCOME STREAM

Helpfully, the AIC (Association of Investment Companies) website has a service called Income Finder which allows you to build your own portfolio, to your own specification, with investment trusts which pay dividends when you want them.

The model includes every investment trust in the AIC’s universe with a yield above zero, and has a walk-through tutorial showing how to add holdings to your portfolio and calculate at a glance what your monthly income stream would look.

‘We launched Income Finder in 2019 to help investors do their research,’ says AIC communications director Annabel Brodie-Smith.

‘You can build a virtual portfolio and see how much cash you might receive each month based on when investment companies usually pay their dividends.

‘If you want a bumper payout in November in time for your Christmas shopping, or just a steady stream of dividends throughout the year, you can tailor your portfolio to your needs.’

Without pushing the boat out by any means in terms of risk, using the Income Finder Shares was able to build a £200,000 pot consisting of 10 equally-weighted holdings in investment trusts which paid a total of £13,073 or an average of £1,089 per month before tax in 2022. 

Even subtracting £2,000 for ongoing charges, assuming an average charge of 1% on the £200,000 investment ‘pot’, the monthly figure still comes to around £923 on average.

Yields ranged from 5.4% to 8.3% and dividend frequency ranged from monthly to semi-annual, with assets spread across a range of equity, bonds, property, renewables and private equity investment trusts.

We have opted for equally-weighted holdings for illustration purposes, but it would be quite possible to increase the level of income by changing the weightings so that there is a higher share of trusts with higher yields.

STICKING TO STOCKS

For those with the time, the inclination, and who don’t want to pay the annual fee for a trust or a fund, there are plenty of stocks which pay attractive dividends.

The trick here is to make sure the dividends are covered by earnings and cash flow, and preferably they should be growing rather than shrinking so your income stream is steadily increasing.

Most firms have the same financial year and pay semi-annual dividends around the same time, so it will take some research in order to build a portfolio of reliable dividend payers covering all 12 months.

Some big companies, like oil firms BP and Shell, personal care group Unilever (ULVR) and the tobacco companies British American Tobacco (BATS) and Imperial Brands (IMB) pay quarterly dividends which makes life easier.

Also, some FTSE 250 and AIM companies pay quarterly dividends, although these stocks trend to be less liquid should you ever need to change your portfolio at some point in the future.

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