Investing for Income: a beginner's guide

Investing for Income is usually seen a strategy deployed on behalf of retired people, to create an income that would supplement a retired person’s income in addition to state and company pensions, however, the strategy can be applied to a wide range of investors seeking not just passive income, but financial security and capital efficiency.

In the UK retail investment market, investing for income traditionally refers to an investment strategy aimed at generating regular cash flow rather than focusing on capital appreciation. This is particularly relevant for investors who need a steady income stream, such as retirees or those seeking to supplement their earnings.

The core idea when Investing for Income is to identify assets that can sustainably pay shareholders a certain amount periodically. When investing, it’s great to buy, for example, a microchip manufacturer share for 10p and sell it on in two years for £1. However, shares that have that trajectory are as common as rocking-horse manure, and you must keep a watching brief on them, timing your trade to avoid the share falling back – which is quite a skill. Moreover, often companies with this trajectory are often in a growth phase and any excess revenue is often reinvested into the company, deployed on acquisitions, or paid out to employees as bonuses.

Alternatively, over time, the same effect can be found by buying an income-producing share for 10p and holding it for a longer period, collecting dividends quarterly, and more-often-than-not preserving the value of the share, which may not go up as rapidly, but will appreciate too, over time. Usually, in the UK at least, the latter share is predominantly an older and larger company with a long history, in an established industry in the FTSE100 Index, shares like Unilever LON:ULVR or Associated British Foods plc LON:ABF.

When you save money in a bank account, you are lending your money to the bank and in return they pay you interest. The same applies to bonds, when an investor can buy a fraction of a bond issued by a government or a large corporation. These bonds provide regular income payments and at the end of their term, the investor gets their money back, the face value of the bond, unless there is a default. Alternatively, investors can buy and sell their bonds before they mature.

Government bonds, also known as Gilts, are sold to brokers, but also to the public through the UK Government’s Debt Management Office. Corporate bonds are often initially sold to a broker, like AJ Bell or Hargreaves Lansdown, and are then sold to investors through the broker’s platform, where investors can trade them. Again, in the case of bonds, the focus is on the provision of periodic, sustained streams of income, as opposed to capital returns.

In this strategy it is important to diversify sources of income, and the best way to do this – without having to monitor multiple positions in bonds and shares – is to outsource this to an Investment Trust or Exchange Traded Fund (ETF), of which there are multiple options available directly from fund managers, or through an investment platform. It is also worth considering Real estate Investment Trusts (REITs), which provide income through rental yields and are required to distribute a significant portion of their profits as dividends, with well-established REITs including British Land LON:BLND and SEGRO LON:SGRO, the latter which focuses on developing opportunities in the commercial space, managing assets in warehousing and industrial properties.

Apart from providing income, which could lead to a more comfortable retirement, or allow you to retire, or partially-retire early, bridging the gap between the end of employment and retirement, there are other benefits from Investing for Income.

Dealing with the tax considerations first, investors receive a tax-free dividend allowance, which in 2024/25 was £500. Moreover, dividends receive different taxation treatment to income depending on an individual’s income tax bands. That said, interest from bonds is subject to income tax. However, if investments are held within an ISA or a Pensions Wrapper such as a SIPP, they are shielded from income tax.

The nature of the investments that go into an income portfolio, means that they are usually less volatile that growth investing – that chip manufacturer share you bought for 10p that went up to £1 could easily return to 10p. In current markets, which are somewhat choppy, income portfolios can weather the storm, and often provide income, even when share prices fall.

It is important to note that unlike growth investing, which relies on stock price appreciation, income investing can generate returns even in falling markets.

Many of the most dependable income-producing stocks are companies that provide products and services that are a ‘need’ as opposed to ‘want’ such as water, power, fuel, food and transportation. The nature of income-investment also means you can reinvest your dividends back into the portfolio, which if you don’t need it is free-money to invest to help you accumulate wealth.

This is facilitated by many investment trusts which offer dividend retirement plans (DRIPs) which automatically buy more shares, and for example, if you invest dividends back into your portfolio, it will often grow faster than taking one’s dividends as cash.

Income-investors have also found over the past few years that their portfolios have been insulated against inflation, and in terms of bonds inflation-linked notes (primarily index-linked Gilts) adjust their interest payments to take account of inflation.

In their construction, an income portfolio often seeks numerous sources of income, pre-baking diversification and risk management into the portfolio. In addition, different assets behave differently in various market conditions – traditionally bonds do well in falling stock markets.

Income portfolios hand independence and agency back to investors, helping them achieve earlier retirement without having to sell assets or remortgage their properties and with passive income, when job security becomes a risk, having alternative sources of income can help you sleep better at night.

Psychologically, as well as helping you to overcome insomnia, an income investor, with a passive portfolio tends to be a lot less emotional than an investor that has an active, growth portfolio as the income investor’s mind-set is to the long term, as opposed to the day-to-day, hour-to-hour worry of a growth investor. Although The Armchair Trader cannot scientifically prove it, an income-investor probably has a lot less cortisol rushing around their bodies than a trader, which bodes for a longer retirement.

Everyone, in short, needs an income to survive.

Although we have so far primarily focussed on retirees and individuals approaching retirement, income investing is also very relevant to other groups of investors who need to prioritise stability over growth, covering expenses and operations, without depleting their capital too quickly, whilst also managing longevity risk.

Some people are naturally more cautious and conservative, some people are risk-takers and idealists. Income investment is much more suitable for the former category, over the latter due to the focus on defensive dividend stocks, investment-grade corporate bonds and multi-asset diversified funds.

The very-wealthy also invest for income, as it helps them maintain their lifestyle and divert returns to accruing physical assets and building their wealth. The tax-efficiency of Investing for Income is also attractive to the High-Net-Worth, reducing their tax liabilities in the most-efficient manner.

Entrepreneurs and business owners could also benefit from Investing for Income, as it can supplement business returns with passive income streams and act as a hedge against economic downturns, ensuring financial stability.

Remaining on an organisational level, Investing for Income is an important tool for charities and foundations, as it provides consistent cashflows, allowing the charity to meet operational costs and distribute grants, avoid volatility and not erode capital. If a charity can maintain its core funding and distribute from income streams, instead of cutting into its core funds it will have greater sustainability.

Finally, at the top of the tree are institutional investors – pension funds and insurance companies – that have many of the same requirements as Charities and Foundations, in that they need to maintain their core funding, disburse regular payments and avoid volatility. Investing for Income provides Institutional Investors with stable, long-term income to cover pension payments, aligning with long-duration assets like government bonds.

While income investing is often associated with retirees, it appeals to a wide range of investors depending on their financial needs. Whether for passive income, financial security, or capital efficiency, selecting the right income-producing assets is crucial for meeting specific investment objectives.

The next year is likely to be one of more volatile in the last decade, given that with global geopolitical crises – not least wars in Europe and the Middle East – a global cost-of-living crisis, falling productivity and migration issues, it’s been a rough ride.

As of this week, stock markets are showing signs of trouble, interest rates are going to fall, taxes are rising and there are lots of itchy trigger-fingers across the world. The need to be efficient with income and minimise financial outflows is paramount.

One way to build in financial protections and minimise tax liabilities is to make full-use of your Individual Savings Account (ISA) allowance this year, but the clock is ticking. The deadline to utilize your ISA allowance for the 2024/25 tax year is midnight on Saturday, 5th April 2025.

This date marks the end of the current tax year, after which any unused portion of your £20,000 ISA allowance cannot be carried forward; it’s a “use it or lose it” scenario.

Key points to consider

• Annual Allowance: You can contribute up to £20,000 across various ISA types, including Cash ISAs, Stocks and Shares ISAs, and Lifetime ISAs.
• Lifetime ISA (LISA) Specifics: For those aged 18 to 39, the LISA allows contributions up to £4,000 annually, with a 25% government bonus. However, the property price cap for using LISA funds has remained at £450,000 since 2017, despite significant property price increases, potentially limiting its utility for first-time buyers.
• Choosing the right ISA: With the deadline approaching, it’s crucial to select an ISA that aligns with your financial goals. Cash ISAs offer tax-free interest, while Stocks and Shares ISAs provide potential for higher returns through investments in the stock market. Be mindful of platform fees and charges, as they can impact your overall returns.

Action steps before the deadline:

• Review Your Contributions: Assess how much of your £20,000 allowance you’ve utilised and determine if you can contribute more before the deadline.
• Select Appropriate ISA Products: Depending on your risk tolerance and financial objectives, choose between Cash ISAs, Stocks and Shares ISAs, or a combination.
• Complete Contributions Timely: Ensure all contributions are processed by 5th April 2025 to benefit from the current tax year’s allowance.

By proactively managing your ISA contributions before the 5 April 2025 deadline, you can maximize your tax-efficient savings and investments for the 2024/25 tax year.