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When working out the passive income potential of a Stocks and Shares ISA, it helps to understand the difference between the ‘accumulation phase’ and the ‘withdrawal phase’.
The biggest difference, in my view, is the huge gulf in targeted returns. That’s because investors still building up their ISAs in the ‘accumulation phase’ can target a higher rate of return. Many investors aim for 10% as a rule of thumb. This is a fairly realistic goal because it is roughly in line with historical returns – but there’s a catch!
The ups and downs of the market make aiming for that every single year a recipe for disaster. The FTSE 100 has returned 14.9%, 10.9%, -0.8%, 26.7%, and -15.3% in the last five years, for example. Therefore, when using the ISA for passive income in the withdrawal phase, a lower return is advised to better protect that hard earned cash.
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Snowballing
Let’s take an example passive income of £1,847 a month. That’s approximately a minimum wage salary now after taxes. Such an income would be quite handsome when paired with a State Pension or paid-off mortgage.
When we reach the withdrawal phase, we aim to withdraw a small amount from our nest egg. Some call 4% each year a ‘safe withdrawal rate’. That means we can withdraw 4% per annum for decades with low risk of eroding the starting capital. On such a figure, the £1,847 passive income requires £554k in a Stocks and Shares ISA – not exactly pocket change!
But the difference between our total return and the amount we withdraw is a crucial concept to understand. For one, it is the reason why we don’t have to stump up the full half a million straight away but we can build towards it. Even a few hundred pounds a month can use the snowballing effect of compound interest to reach a nest egg of many hundreds of thousands.
Portfolios
It’s no secret that a great many stocks on the London Stock Exchange pay far more than 4%. For example, Phoenix (LSE: PHNX) offers a 7.86% dividend yield at present. This doesn’t look like a flash in the pan either. The forecasts for the next two years are 8.01% and 8.24%. Does this mean we can withdraw at these higher amounts? Well, yes and no.
Yes, because building what some call a ‘high-yield portfolio’ around big dividends is a valid strategy. While double-digit yields are almost always unsustainable, the higher single digits have a better track record. Phoenix, for example, has offered above 6% for the last 10 years.
On the other hand, this strategy has risks. One is less share price appreciation. The Phoenix share price is up only modest amounts even going back a decade or more. Share prices can fall in value too, leading to a smaller cash pile in my ISA.
Another risk is simply that dividends are never guaranteed. The 2008 crisis sparked a raft of dividend cuts and cancellations. The 2020 pandemic likewise. One of the historical great dividends from Shell, increased every year since 1945, was cancelled after one restaurant goer in China made the somewhat unwise decision to have bat for dinner.
Personally, I think Phoenix is one of the better income stocks on the FTSE 100. I’d say it’s worth considering.
