I often read comments from private investors – or even in magazines and newspapers – suggesting that to live off investment income you should choose your holdings according to when the income is paid.
According to this theory, a high yield portfolio [1] ought to have some shares that pay dividends in January, some in February, some March, and so on, to spread the income over the year to meet your monthly spending needs.
The same holds – they say – for other sorts of investments. Most income trusts [2] pay their dividends quarterly or twice a year, so the investor is urged to pick their trusts accordingly. Or you’ll hear buy-to-let property being touted specifically because the inflow of cash from rent will arrive on a monthly basis.
But this is a crazy way to live off investment income [3].
Firstly, you should not be relying on such income to arrive on a monthly basis like a salary. It’s too precarious. Rent can be skipped, dividends cut, and the interest on cash slashed.
Secondly, you shouldn’t be spending all your money every month anyway, hoping you can make it to the next dividend. There are many reasons to live off investment income, but a stressful life is not one of them.
Thirdly, you cannot afford to add the spurious requirement of ‘When will I get paid?’ to your selection process when designing your income portfolio. You need to focus on asset allocation, diversification [4], and other more important factors.
You may even want to own some assets that don’t produce an income at all, but will either need to be periodically sold down (for instance a gold ETF) or else that mature as a lump sum (such as an NS&I index-linked bond [5]).
Finally, I’d urge people pursuing lifetime financial freedom to continue reinvesting some of their investment income after quitting work, at least early on. Again, monthly get-and-spend thinking works against that.
A better way to live off investment income
You need to decouple your income streams from your outgoings, in a methodical and modifiable way:
1. Set up a cash buffer account between your regular monthly spending, and your income-spewing engines.
2. Work out how much of your annual investment income you will/can spend. The rest of the money you will reinvest.
3. Load your buffer account with a very healthy float of money.
4. Direct all your investment income to be paid into the cash buffer account (by a proxy current account if need be) and set up a monthly direct debit out of the buffer and into your spending account. The monthly debit from the buffer is your permitted annual spending amount from step #1, divided by 12. This is the money you can spend each month!
5. Finally, as your buffer grows (because you’re taking less money out than you’re paying in) you occasionally reinvest the surplus back into your income investments.
Now, compared to spending your dividends and your other income the moment it arrives, this system does mean you’ll require a bigger investment pot – or else you’ll need to live on less money than you’d hoped. The cash buffer will gobble up a chunk of your funds, and the safety margin you’ll be reinvesting also cuts your monthly spending.
But the reward is a rock solid monthly income, infinitely greater piece of mind, and a portfolio chosen entirely on its merits that can easily be modified to accommodate lumpy investments such as maturing bonds or capital growth products, as well as non-investment income such as gifts from older family members, or piecemeal part-time work.
Tips on setting up your income pipeline
I have previously written about creating an income portfolio to replace your salary [3], so please do read that article for more on building your income portfolio.
Also, I am ignoring tax, since everyone’s circumstances vary. Needless to say, you should set up your income system in a tax-efficient way, using ISAs, SIPPS, and your annual capital gains [6] allowance.
Here are a few other tips on designing your income regulator:
Keep at least a year’s spending in your cash buffer
I suggest you hold at least 12 months total spending in this buffer, and preferably more. That might seem incredibly tough, but in the mid-1970s and again in 2008 dividend income dived in real terms. Also, rent can go AWOL, interest on cash can be cut, and formerly rock solid vehicles like PIBS suspended. If you’re living off investment income, you need a safety net.
The cash buffer should be in multiple high interest accounts
Conceptually, it’s one ‘float’ of cash, but for insurance purposes you should spread your money between two or more banks. Take into account the maximum compensation per bank from the FSCS guarantee scheme [7] (currently £85,000) but spread your money anyway – if one bank melts down you will still need to eat while you await your compensation. You may also need to employ multiple accounts to be permitted sufficient annual withdrawals at a decent interest rate.
The buffer should pay interest, and remember inflation
With 1-2 years worth of spending money in it, it’s vital you keep your cash in the best paying interest account you can find. Be prepared to move it when the rate is cut. Also, you’ll need to increase your total buffer with inflation every year. In the good times, the interest might handle this, but if not you’ll need to top up.
Spend less than you generate: Perhaps 75%
Just as it’s good practice to spend less than you earn when working, it is sensible to spend less than you can when living off investments. There are two good reasons. Firstly, you can reinvest the spare money to grow your income stream, which will help you beat inflation – especially vital with fixed income. Secondly, should a financial disaster strike and your income nosedive, you’ll hopefully not feel the pain.
(This might sound like a platitude to frugal Monevator readers, but in the real-world people would be thinking fancy cars, gym bills, three foreign holidays, and all sorts of other commitments. This second safety margin is especially important if you retire from work very early – there’s hopefully a long way to go!)
Flexibility with lumpy income
A helpful thing about this system is it’s able to accommodate all kinds of income streams with ease, including passive income [8], part-time work, annuities, inheritances, capital sales, and more. Just lob it all in the buffer and adjust as required.
Tweak and tack as she goes
After a year or two you can revisit your figures and adjust if you’re being too generous to yourself – or even too mean! If your investment income rises dramatically, you can consider increasing your spending. If it dives, dial down your monthly debit.
You’ll also need to rebalance your portfolio [9] as usual, of course, and move towards safer fixed income investments as you age [10]. You also might increase your spending as the final curtain draws near, unless you’ve heirs to worry about – or perhaps spend twice as fast, as the case may be!
If you’ve made your own plans to live off investment income (or you’re already doing so) then please share your tips in the comments below.