When most investors decide that they want to start taking a regular income from their portfolio, perhaps they have recently retired, they simply inform their fund platform or broker of the amount they wish to withdraw. Assuming they have the funds available the money will automatically be deducted from their investment each month, or whatever frequency they want, and paid into their bank account. However, this is often not the best or most sustainable way of withdrawing an income from an investment portfolio. That's because prior to commencing income withdrawals their investment strategy will likely have been very growth focused.
That means they will have typically invested in funds that don't pay a natural income and automatically reinvest any dividends that they generate. A growth orientated investment portfolio won't produce much in the way of natural income as the companies the underlying funds invest in won't pay out much dividend income, instead preferring to use the money to grow their businesses.
Therefore when it comes to taking an income from your portfolio you will end up simply encashing chunks of it to live off. In essence you are living off the capital gain that your portfolio produces. The problem with this strategy is that you need to produce a capital gain to match the size and frequency of your withdrawals. This is incredibly unlikely as the example below illustrates.
Let's say you have a portfolio of £100,000 and want to take £5,000 a year as income and your portfolio uses a growth strategy. Let's say that your portfolio grows 5% in year one. That means it is now worth £105,000 and you take the £5,000 as 'income'. This leaves you with £100,000 again, so far so good. Let's imagine that in year two the market falls 10%. You now have £90,000 and you still need your £5,000. So at the end of year 2 you have a portfolio worth £85,000 (i.e £90,000 - £5,000).
You now need your portfolio to grow by 23.5% in year 3 so that it is worth £105,000 by the end of the year so that you can withdraw your £5,000 and still have your original £100,000. This is incredibly unlikely.
In fact what will happen is that your portfolio value will plummet until you run out of money or you will need to reduce your income withdrawals.
The best way to draw an income from your portfolio
The best way to build a sustainable income stream from your investments is to build an income portfolio. To do this you need to invest in funds, usually equity income funds, which produce a natural income stream from dividends. Equity income funds invest in the shares of companies which prioritise paying money to shareholders in the form of dividends. Let's say that you invested in a portfolio of funds which pay out 5% in natural income, or in other words have a 5% yield. The yield is with reference to the price you paid for the funds when you originally invested.
When you invest your £100,000 in a portfolio of funds with a 5% yield then you will receive £5,000 a year income regardless of how the value of your portfolio fluctuates. This is because income fund payouts are referenced in pounds and pence per unit held in the fund and not as a percentage of the fund value.
So if at the end of year 1 your portfolio is worth £100,000 it will naturally pay £5,000 of income. If at the end of year two your portfolio is worth £90,000, because the market fell, your portfolio would still pay out £5,000 and so on and so on.
It doesn't matter about the capital value of your portfolio just that the funds are able to maintain their payouts.
How 80-20 Investor can help you build the Perfect Income Portfolio
While understanding the need to construct an income portfolio is simple enough, constructing one is difficult. That is because you need to find funds that:
- pay a yield that matches your income requirements
- are likely to maintain that yield and not cut their income payouts
80-20 Investor provides not only the research to help growth investors but also income investors. To empower members to quickly build a portfolio that can provide a sustainable income stream is no mean feat. It takes weeks of research, research that would cost thousands of pounds if you were even able to obtain it from another investment professional.
Our UK Income fund Heatmap and Global Income fund Heamap summarise this research into a neat visual aid. The research analyses all the main UK equity income and global equity income funds that aim to provide investors with an income stream. It analyses the actual pounds and pence that investors have received from these funds going back 10 years as well as how this income has grown over time. It also looks at the current yield that you can obtain from these funds and its recent annual growth rate. It is sensible to diversify your income portfolio by investing in one or two global equity income funds as well as UK equity income funds.
It is worth mentioning that different funds pay their income at different times of the year and at different frequencies (monthly, quarterly or yearly). So in order to provide a regular monthly income stream to live off you should create a cash buffer containing one year's worth of income and invest the rest of your money in an income portfolio. You can then withdraw money each month from your cash buffer to live off while at the same time your income portfolio tops the pot up as and when the dividends are due. In this way at the end of 12 months your cash buffer should be worth the same as it was at the start of the year. So long as your desired income does not exceed your portfolio's yield you will be fine.