Income to pay the bills

Shares magazine this week has a cover feature on how your ISA can pay you £10,000 a year tax free. It’s worth a read if you are a subscriber.

Spending

It suggests that £10,000 would cover “essential spending” if you are retired and have no mortgage or rent to pay. So I thought I would test that against our essential spending, as defined by me, for 2018. On a first look we’re spending significantly more. If, however, I re-state petrol, public transport, life cover, TV licence, Dentist, Mobile phone, and landline calls as “luxury” spending then we are only 16.71% overspent.

We’re overspent on every category except “other”, but this is to be expected perhaps with a family of four. This exercise does show, however, the importance of knowing exactly how much you are spending in total and by category, and whether you consider it essential or luxury.

Income

The article further suggests that you would need to be looking to have a 5% income yield on your ISA investments. They then suggest five investments yielding between 4.8% and 8%, giving an average of 6.3%. I would suggest that as an investor you would not equally weight these five investments but should overweight the mainstream funds and underweight the higher yield shares and funds thus reducing the yield to 5.7%.

I compared that yield to that of my ISA as at 31 January which is 5.4%. So I think the yield suggested is reasonable so long as you are prepared to look for yields higher than the FTSE100 index.

My holdings are all funds but they include international equities, property and bonds none of which are represented in their recommendations. Only 36% of my ISA holdings are UK equities comparable to those recommended. Also, mine are all in funds (investment trusts), with no individual company shares being held, so they are more diversified.

Capital

The article suggests that capital of £200,000 is required in order to produce £10,000 of income from a 5% income yield. They suggest saving £10,000 each year in an ISA for fifteen years, and assume 4% real growth (after inflation) in order to end up with over £200,000. As the recommendations could produce a 5.7% yield this actually reduces the requirement to £176,000 and the time taken to fourteen years.

Looking at actual FTSE All Share total returns for the last fifteen years shows compound growth of 7.18% each year. The Retail Price Index (RPI, other indices are available) shows compound growth of 3.00% each year over the same time period. This suggests 4.18% per year real return just slightly ahead of the assumption and not enough to reduce the time by another year.

This compares with actual returns for my portfolio of 8.71% each year, or 5.71% after inflation over the fifteen years to 31 December 2018. These returns and assuming an income yield of 5.4%, and an income requirement of £11,671 suggest a target of £217,000, and that it would also take fourteen years.

Conclusion

I find it useful to review published ideas against my own thinking and my own historical experience. In this case saving and investing over fourteen years could produce the required outcome based on recent returns and current portfolio yields in both cases.

Being able to save and invest £10,000 each year for fourteen years would be more of a challenge – but that is for another day.