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Fool's Eye View

[ November 6, 2000 ]

Retirement Pays Dividends

By Stephen Bland (TMFPyad)

Let's say you have retired with a lump sum available from your pension plan, or maybe have been made redundant with a payoff. Alternatively ,perhaps you have been saving hard for a long time and have created a fund to invest for income. What should you do? What options are open to you as an income seeker? There are a very large number.

Conventional wisdom on this topic from IFAs will tend to propel you in the direction of some kind of insurance company product such as guaranteed income bonds or the like. A lot of literature on the subject of retirement investing for income suggests that, even if you have been saving through equity vehicles of some kind up until now, there should be some switch away from equities just because you have retired.

Advisers make such comments because of the perceived risk of keeping money in shares, it being felt by them that at the age of, say, 60, one should be taking less risk than before with savings. From what I have seen, the great majority of retirement lump sums end up either in insurance company investments, or simply in National Savings and bank and building society deposits.

My proposition is that far from avoiding equities, retirement income seekers should actively migrate to this form of investment, even if they have never done so before. It is an option that is considered only rarely, particularly by IFAs. The fact that there is no commission available on such an arrangement has, of course, nothing to do with it. However, I have to say that even other sources such as articles in the press on this topic will rarely suggest shares as a great place for income investing.

But you are not reading The Motley Fool in order to find the same answers to investment questions as those to which the financial establishment might try and direct you. We are here to offer ideas for people who wish to take charge of their own financial lives and I believe that certain shares provide almost the ideal answer for income seekers, though there are some risks involved as I will show later.

The life expectancy of a 60-year-old man is quite long. For a lady, several years longer than the male. Anyone with a lump sum available to invest for income upon which they depend must therefore try and find a source that will grow that income and also offer some easy access to the capital. Inflation is the obvious reason that it is essential, for those that do depend heavily on the income, to try and ensure that it will grow. Having the capital available may be important at some future point if, for example, you have to go into a care home.

So what I am suggesting is a portfolio of high yield shares. This offers the attraction of a decent commencing yield, the likelihood that it will grow, and the likelihood also that over longer periods the capital may grow as well.

Whatever the money available, even very large sums, no more than about 15 shares are necessary to take strip out the excessive risk of too few shares. Stick to FTSE 100 companies and spread the holdings around sectors. I would do it by ranking the shares in the index by descending yield, then work down the list choosing one from each sector, but doing a bit of research on each potential candidate. You don't want excessive debt, for example. Another useful clue is to pick only those companies that have increased dividends regularly over the last few years.

At present yield levels it will be quite simple to achieve a starting yield of 4-5% on the portfolio. Having chosen your shares, simply buy and hold forever. Do not be tempted to meddle, and try not to let press comment on your companies influence you. Do not worry about the fluctuations in the underlying capital value of your shares that are certain to occur.

With this strategy, there is a very good chance that you will derive an increasing income, and that your capital may well increase over time as well. However increasing income is the primary object with the scheme, capital growth being merely the icing on the cake. Note also that your capital is freely available to you at any time at the market price should you need to realise it, a valuable feature. Many insurance company products compel you to tie up your money or impose penalties on withdrawal.

I wish to stress, though, that anybody considering this approach must be made aware that there are risks. Neither the income nor the capital is guaranteed. If you cannot live with that then, clearly, don't do it. I believe, however, that the risks are less than many people imagine.

If you look at blue chip shares, the trend is for them to increase their dividends. In a 10-15 share portfolio, even if one or two of the shares go through a bad patch and cut their dividends, it is pretty likely that the growth in the others would more than compensate for this.

In my view this is one of the few ways that an income investor can obtain a good chance of a growing income, with the subsidiary likelihood of long-term capital growth. And if you are interested in shares it could be enjoyable too. A nice further advantage is that there will be no charges to pay to an insurance company or adviser other than the small initial purchase brokerage. Add in the free availability of the capital at any time, at the market price, and you have a powerful set of reasons, in my view, for choosing equities to create an income source.

Oh, I nearly forgot: another strong reason as well. For basic rate taxpayers, there is no tax to pay on dividends under current legislation. Unlike interest, for example, which carries a tax liability of 20%. And if you are a higher rate payer, the tax on the dividends received is limited to 25%.

I never advocate tax-led investing, but advantageous dividend taxation is just the cherry on the icing on what is already a pretty tasty cake.

Where Next?

• Learn how to create your own retirement plan with the Fool's latest interactive online seminar!
• Retirement Investing discussion board