The idea of creating an income stream which you get paid without working is nothing new, it’s actually the fundamental basis of any retirement plan. However the concept has been repackaged as ‘passive income’ in recent years, as people of working age seek to make more of their assets and abilities to boost their income. It covers all sorts of activities such as hiring out garden tools through to renting out a room to lodgers.

DON’T FORGET THE UPFRONT COSTS

There is almost always an upfront cost to creating passive income, but the idea is that it requires little continued effort to keep the money rolling in. Building up a portfolio of income investments fits neatly into this category. Once you’ve saved enough for a portfolio which provides you a reasonable income, your working options open up, whether that might be going part-time, retiring early, or retraining in a new field.

How much you need to build up depends on what your income needs are, but once you’ve built up the necessary capital, you’ll need to invest it for income. One way of doing this is to invest in individual stocks. There are plenty of companies in the UK stock market which provide relatively healthy dividends, though high yields are not necessarily the only indicator you should look at when selecting investments.

A historic dividend yield provides you with information on what the company has paid out in dividends in the last year, but sometimes the market adjusts the price of a stock downward because it’s expecting dividends to be cut. That can result in a historic yield which looks high because it relates to last year’s dividends, which aren’t repeated going forward.

LOOKING AT DIVIDEND COVER

Investors should also consider the dividend cover of a stock, which is the amount by which its earnings cover its dividend. This is given as a multiple, for instance a dividend cover of 2x means that annual earnings are two times bigger than annual dividends, which suggests a company can continue to pay out its dividend unless earnings fall by 50% (though of course it may still choose to cut its dividend if its earnings fall by less than that).

On the other hand, a company with a dividend cover of 1x is skating on thin ice in terms of its income payments, because any reduction in earnings could well mean having to cut the dividend, or fund it through debt.

Another couple of considerations when picking income shares is dividend volatility and dividend growth. Some sectors have more volatile dividends than others. For example, consider mining companies, which derive their earnings from commodity prices. When these are high, the money is rolling in, and dividends can be generous. But when the cycle turns and commodity prices fall, mining companies can see their profits collapsing and might have to take an axe to dividends. Compare this with supermarkets, where demand for their products is relatively stable, and so their profits and dividends are less volatile.

CONSIDER DIVIDEND GROWTH

Dividend growth in the future should also be factored into investment decisions. A company with a high stable dividend may give you jam today, but if the dividend remains flat over time, your income is vulnerable to the effects of inflation. A company which has a good track record of growing its dividend can offer you some protection here, though there is of course no guarantee it will continue to do so indefinitely into the future. Stocks with higher dividend growth potential tend to come with lower starting yields. An income portfolio might therefore include stocks with a high but flattish dividend to boost income in the here and now, alongside companies with lower yields but better prospects for dividend growth.

To run a truly portfolio of individual stocks you really need a minimum of 25 to 30 companies to achieve an adequate level of diversification, to protect you from problems in one company or sector damaging your wealth too badly. For many people, that’s a lot of portfolio management to take on, which is where funds come in.

FUNDS OFFER DIVERSIFICATION

An income fund run by a professional investment manager offers you instant diversification, as well as someone to pick stocks on your behalf, though there is of course a fee for this service, to the tune of 0.81% per annum for the typical UK Equity Income fund, according to Morningstar data.

Equity Income funds investing outside the UK can also help you diversify your portfolio globally and are definitely worth considering. You may have to accept a lower yield from some markets though, but sometimes that might come with better prospects for capital growth.

Like open-ended funds, investment trusts also offer a diversified portfolio of shares and are run by a professional manager. Income trusts can also manage dividend payments to their shareholders by holding back money in good years to pay out in fallow periods. This doesn’t mean investment trusts receive more dividends than an equivalent open-ended fund, but they can smooth the income as it is paid out each year, which will be attractive to some investors.

It goes without saying if you’re investing for income, you should keep the taxman off your dividend payments. By holding your investments in an ISA, your income from investment faces no income tax, and also no capital gains tax. So, for passive income seekers, making the most of your ISA allowance to save tax and keep more of your income is a no brainer.

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