The Motley Fool
In my opinion, it’s never too late to put in place a strategy to generate passive income.
But everyone’s individual circumstances are different. This means some leave it until later in life before addressing the issue of how they’re going to have enough income to fund a comfortable retirement.
Assuming a retirement age of 67, starting at 40 still leaves 27 years to build a nest egg.
My strategy (indeed, one I’m already following) would be to save as much as possible and buy UK stocks.
I’d keep reinvesting any dividends received and then, when the time comes to retire, switch into high-yielding shares, and live off the passive income.
Fabulous five
According to AJ Bell, the average yield of the five best dividend stocks in the FTSE 100 is currently 10%.
But it’s important to remember that returns to shareholders are never guaranteed.
And a stock with a high yield might be a value trap — a share that looks to be a bargain but is the opposite.
However, for the purposes of this exercise, I’m going to assume that it’s possible to generate a 10% annual return.
The golden years
The next issue to be addressed is how much income I’m going to need later in life.
It’s usually assumed that less is required in retirement.
The UK average salary is currently £34,963 a year. Let’s say I will need around 50% (£17,482) of this for a comfortable lifestyle.
At first sight, this might appear to be an alarming drop from the average, but remember, the State Pension age is also 67. Those eligible will receive £10,600 a year at today’s rate to add to that amount.
Assuming a yield of 10%, an investment portfolio of £175,000 is required to generate an annual income of £17,500.
Possible returns
So, how much will a 40 year-old need to save to reach my earnings target? The answer depends on the rate of growth of the stock market.
From 1984 to 2022, with dividends reinvested, the average annual increase in the FTSE 100 was 7.4%.
Again, this isn’t necessarily going to be repeated.
But if it was, investing a lump sum of £2,054 at the start of each year, for 27 years, would turn into £175,064.
Assuming our ‘fabulous five’ continue to deliver the same returns as they do now, this would provide me with an annual income of £17,506.
It’s possible to exactly match the performance of the FTSE 100 by investing in a tracker fund.
However, other stocks have historically delivered better returns. For example, over the past five years, Frasers Group has seen its share price increase by 193%.
By contrast, the stock of International Consolidated Airlines Group has fallen 64%.
A tracker would help reduce the risk of buying the ‘wrong’ stocks.
Final thoughts
But all of these figures are sensitive to the assumptions made.
If the FTSE 100 grew at a rate of 5.3% (the historical return without dividends being reinvested) it would take another six years to achieve the same result.
If I invested for another 13 years, at 7.4% per annum, my retirement pot would be £448,445.
Clearly, it’s better to start earlier than 40, and save more.
But don’t let the perfect be the enemy of the good. My advice would be — whatever someone’s age — they should start investing!
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