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 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 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.
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, 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).
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, 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 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 (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, 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 as usual, of course, and move towards safer fixed income investments as you age. 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.
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Do my eyes deceive me, or is Monevator becoming a goldbug? In which case the end is truly nigh 😉
I’ve never understood monthly income dividend shenanigans either. If people live so hand to mouth I’m not sure they are suited to living off investment income, or indeed anything other than a steady job 😉
Your 2 year cash buffer seems to be the obvious way to go – one year as a filter to smooth the income and the other year’s worth as an emergency fund to clear essential repairs, or to ride the impact of a stock market crash, which so far haven’t lasted > 1 year in my experience. The 1930’s Great Depression was longer, however, would favour a three-year buffer. Which is what I have targeted with a Cash ISA and NS&I.
Unfortunately I am along way from being able to live off investment income, but having this option is a major investment goal (and motivation) of mine, and this was an incredibly useful and thought provoking piece. Many thanks!
Nice stuff monevator but perhaps you could make it clear that this piece is aimed at someone living the “normal life” which involves work, work, work, save save save and then sit back and live off investments.
As Neil points out above most people will be a long way off from this point. And if the plan is to spend just 75% of your income then you’ll need 33% more fund to achieve your income goal.
Take someone wanting say £30,000 to live on.
They’d need a fund of around £1million. (assumes 4% net yield and spend just 3%) – i guess that’s out of reach of many.
But there are plenty of folk out there who want a different plan. A plan to have enough money to take a big break, to change their lives, take a new direction by re-training and or starting their own business to earn some money in their later years. For these people they need enough to fund the period it will take to change direction – say 3 years. Which in this example is c £90,000 – perhaps done in conjunction with some serious pension saving to facilitate that change well before normal retirement whilst you still have some energy !!
It’s still not cheap but it’s another equally valid way of planning your life and your money.
There’s no one answer – we’re all different but this is the plan I’m living.
Very similar to my own thinking.
Perhaps two tweaks:
– if you are aiming to retire early, you will get there sooner if you live on less: I reckon a family with 2 kids can live reasonably well on £20k (when the mortgage is paid), it is surprising how much you can cut back on expenditure
– increasing the yield on your investments will help: I continue to look for safe (-ish) high-yield options, e.g.
http://www.the-diy-income-investor.com/2011/07/guaranteed-9-yield.html
Perhaps it’s because I’m an American and have different investment options or maybe it’s just that I don’t put much effort into diversifying across industries, but I’ve found it relatively simple to generate monthly dividend income.
Bond funds and a couple of REITs pay monthly, so they form a base. From there I just build up positions in dividend growth companies that pay quarterly, looking for the best ones I can find in each of the three months. Filling the March/June/September/December months is the most difficult, so dividends then tend to be 10%-20% less in those months. The overall yield is high enough (currently 6.5%) to sustain a sane withdrawl rate and allow for reinvestment… not that I’m ready for withdrawls yet!
Agree that a large cash buffer is essential for smoothing the income.
And, as a point of reference, my dividend income choices in 2008 only suffered a 10% drop in total dividends. Checking with other dividend growth investors, they had similar results while a few actually had income boosts.
Thanks for the great comments all!
@ermine — Hah, I wouldn’t say conceding some people may have or want to have a gold ETF or other non-income generating asset in their portfolio makes me a gold bug? And while I don’t much fancy the look of gold right now, I wouldn’t say never. (Here’s an article on that very subject! 🙂 )
@Neil – Thank you. A target and a plan is the first step!
@Paul – Thanks for your feedback and thoughts… I’ve got to say though that given I said tax is going to fluctuate depending on different people’ circumstances, talking through all the variations of funding 1-n years of doing 1-n different activities is certainly beyond the scope any article! 😉
I would say if someone really wants to take three years out and fund it from savings, then they should just be in cash and possibly some short term government bonds. That’s it!
Of course, someone may want to do something like half investment income and half part time work, which to be fair I did allude to in the article. In this case I would still use a very similar system — I’d treat the part-time income as another dividend stream going into my buffer etc.
The issue of ‘how much is enough’ is yet another article (and one I’ve ducked before – another huge variable). But I think you’re 4% gross real return p.a. with 3% to spend is a decent enough long-term target (I’d personally hope for 1% more I think). After that you can think of each £100K buying you £3K say in today’s money, in perpetuity.
@Moneyman – Very much agree, I could live on £20K investment income outside of London/similar, especially as it would be pretty easy to avoid all tax on that if structured properly. (Not spending taxes, obviously).
@George — Yes, a good illustration there that income tends to be much less volatile than capital values, even in big downturns. That said a UK investor in blue chip REITS like Land Securities would have seen their annual income from the share halve between 2008 and 2010. It’s why I and others stress diversification when building income portfolios.
As for the monthly income angle, US stocks do pay far more quarterly dividends than UK ones (and have influenced the likes of BP and HSBA into doing so). But even if it’s doable, it’s really not a good way to think about what share to buy IMHO.
Every time you buy one security over another, you’re weighing one set of good traits and compromises against another. “Does it pay in June?” would be at the very bottom of a list of several dozen (hundred?) criteria for me. I’d look at almost anything else first.
This was in a news paper a few years ago so not sure who to attribute it to, but i liked it for future refrence
* Keep the next six months of required income in cash.
* Keep the next 2.5 years of required income in term deposits or government stock of appropriate maturities to satisfy the first point.
* Keep the next seven years of required income in high-grade corporate bonds or capital notes of appropriate maturities.
* Keep the rest in New Zealand or international shares, where it will grow faster.
As the respective items mature, put what you need into cash and reinvest what’s left over to try to keep the term deposit and corporate bond maturity structure intact.
Mate, what is the dividend tax rate in England? Here it’s 15% going to 20%.
If you’re outside the higher rate bracket (which most seeking financial freedom will be… A passive investment income of less than almost £45,000!) then there’s no more tax to pay on dividends received.
Higher rates are effectively 25% and there’s a super rate paid by almost nobody reading this of c.32.5%.
@Ron — interesting, thanks. I think that strategy will run out of ready cash of the top of my head at current yields though. Also, I wouldn’t put too much of my total share portfolio in non-domestic currency, even 7 years out, due to currency risk. I’d favour diversification with a strong overseas bias if you like, and regular rebalancing.
Be careful when working out how much dividend income you can earn without any more tax.
If you get a dividend on £90, I’m pretty sure that the sum you use to check against tax brackets is £100 as the 10% tax already deducted needs to be added back on. This also applies when looking at the £24k limit after which your age related personal allowance starts being removed, which will result in a 30% tax bracket for any income from a pension.
You also need to “stack” capital gains on top of earned income, interest income and dividend income, so you can hit the 28% CGT band faster than you might like.
I’ve got a spreadsheet that models the situation for my wife and myself for the 7 years to retirement, the 11 years after that until state pensions at age 66, and the five years after that. Yes, I am that sad!
@gadgetmind – yes, very true, good comments. Am trying to keep things simple on this page without going deep into dividend lore but you’re right to sound that note.
Again, circumstances will vary. My own targets presume c. £5-10k per annum personal earnings, for instance, largely falling below the income tax threshold. Etc!
Would LOVE to see your spreadsheet! 😉
I agree with the main idea, but the buffer account seems too complex to me. You are really asking for banking facilities on multiple high interest accounts. Is this feasible?
I just get all investment income paid into a current spending account (along with salary) and then dump surplus into other interest bearing accounts. Yes, it means keeping a healthy, non-income generating amount of capital, but I can open and close other accounts without having to redirect investment income.
In the situation where all income derives from investment, surely it would be easier just to top up a spending account from other accounts?
@salis — Yes, in practice you may have to sweep income into a current account then push it out to the savings accounts via a direct debit. Hence the mention of potential need for multiple savings accounts (since many only allow say 4 withdrawals a year).
I didn’t want to get into specifics because savings accounts change and I’ve been closing cash accounts for 2 years more than opening them.
It’s important to clarify though that to some extent I’m proposing a NOTIONAL system here. (Shouting as no bold on iPhone!)
In reality I’d be running this as a spreadsheet or a framework, more than a literal system of buckets.
I’ve noticed many people prefer to have concrete setups though. Even there though there’s a notional element: eg You might have a current account and a pseudo current account, and most of your cash buffers are effectively long term and untouched savings.
The key is how you mentally apportion the money I think. Cash as a three year buffer for one set of reasons is different to cash kept for portfolio reasons.
Hopefully people will read the article and strong comments & figure out a system to suit.
As long as they’ve stopped thinking about buying Company X to plug an income shortfall in September or what have you, that’s a good start!
Thanks for your thoughts.
Surely a “massive” cash buffer buffer is pretty inefficient, long term.
You have a load of money pinned, unable to invest.
Why not keep a *much* smaller buffer and stay invested? The assets are liquid, so can be sold down very easily (a few days wait). The only risk is you *might* need to sell *some* of your investments during a market drop. Big deal. I’m getting all the gain all the other while.
Such a large buffer says; you’re going to get no dividends or interest ever for 3 years? Really? Did the world get hit by a zombie meteorite plague? We’re all doomed then anyway (even gold bugs, sorry).
I can appreciate the desire for safety (which to paraphrase Tacitus, runs counter to any noble enterprise) but the long term risk of pessimism seems a much higher cost, particularly with such a large amount of hard-earned.
And besides, Mr MM seems to do exactly this with much success.
What do I miss?