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Passive income is a phrase investors hear a lot these days. Basically, it means a second income that we can generate with minimum effort on our part.
Mostly, earning money takes sweat and graft, but investors who build a portfolio of FTSE 100 income stocks can let them do the heavy lifting instead.
UK blue-chips pay some of the most generous dividends in the world. The average index yield is typically 3.5%, while in the US it’s lower at around 1.2%. Some FTSE 100 stocks offer as much as 7%, 8% or even 9%.
As a rule, it’s not a good idea to draw dividends as income while of working age. It makes more sense to reinvest them. That buys more shares, which in turn produce more dividends, creating a powerful compounding effect.
While investing in equities is riskier than putting money in the bank, history shows the long-term total return is usually stronger. But it takes time. This is no get-rich-quick scheme.
Building long-term wealth
Let’s take the example of a 30-year-old who’s managed to build up £30,000 in a Stocks and Shares ISA. They might need to raid that pot one day, perhaps for a property deposit. But what if they leave it invested?
If it grows at an average 7% a year and they don’t touch it until they’re 65, that £30,000 could grow to an impressive £320,297. And that’s without adding another penny.
Drawing 4% of that as income, often called the ‘safe withdrawal rate’, would produce £12,812 a year. Not bad from one initial lump sum.
That money won’t go as far in the future though, as inflation will eat into its buying power. This is why our investor should ideally keep adding to their ISA.
Say they invest an extra £300 a month. By 65, they’d have £852,785. Taking 4% would generate £34,111 a year, a much stronger base for retirement.
Of course, results will vary depending on how markets perform and which shares they choose. I think there are plenty of attractive dividend stocks on the FTSE 100 right now. One that catches my eye is insurance group Admiral (LSE: ADM).
Admiral for income
Admiral is best known for motor insurance but also sells household and travel cover. On 14 August it reported a massive 69% increase in pre-tax profits to £521m, as margins grew due to falling insurance prices.
There was good news for income seekers as the board hiked its payout 62% from 71p to 115p. The trailing yield is now 4.51%, but that’s forecast to hit 6.58% in the year ahead.
Investors have enjoyed growth too, with the shares up 18.5% over the past year. The price-to-earnings ratio is 15.3. That valuation isn’t cheap, but it’s not expensive either.
No stock is without risk. Admiral operates in a competitive market. Broker Shore Capital has warned that underwriting margins may deteriorate, threatening profit. But I still think this one is worth considering for income and growth.
I never put too much money in one place because of the overall risk. A balanced portfolio of 15 to 20 FTSE 100 shares seems about right to me. The earlier investors start, the longer that passive income has to compound and grow.
This story originally appeared on Motley Fool
