Many people invest in shares to build a fund for retirement. Often the idea is that by investing over time, the pot can grow for when retirement day comes. That makes sense to me, but I also look at it from another perspective. If my retirement savings start to generate substantial passive income streams, could I actually bring forward my retirement?
Let me explain with an example.
The power of compounding
A lot of investors understand dividend yield. But not all necessarily realise that seemingly small differences in yield can make big differences to the long-term return from a share.
For example, imagine I could choose between Direct Line with its 8.2% yield and competitor Legal & General, which currently yields 6.5%. At first blush, these may seem like quite similar investment ideas. They are both financial services groups with a strong focus on UK insurance. They both have well-established brands. They both offer a big dividend, with less than a couple of percentage points of yield difference between them.
But imagine I invest £100,000 today in Direct Line, reinvesting the dividend each year into more shares. Presuming the share price and dividends remain the same, after 20 years I would have £484,000. At that point, the annual dividends would be worth just under £40,000 a year. By contrast, if I put the money into Legal & General shares, using the same presumptions, after 20 years I would have around £352,000. It would produce nearly £23,800 in annual dividends.
How I could retire early
That is a big difference!
The lump sum after 20 years would be markedly smaller by investing in the lower-yielding share. On top of that, my annual dividend income would be little over half as much. If I wanted to retire by starting to receive the dividends instead of reinvesting them, the sooner I could get my dividend income to the desired level, the earlier I could stop work.
Of course, over 20 years all sorts of things could happen. Insurers could see profitability decline due to new competition. One of the companies could lose market share, hurting profits even if the insurance market overall does well. But the point is clear. Seemingly small differences in dividend yields could be important in bringing forward the time I can reach my retirement investment goals.
That is why I hold a number of high-yielding dividend shares in my portfolio. Given that every share has risks, I make sure to diversify.
One I hope can help bring forward my retirement is Imperial Brands (LSE: IMB). The tobacco company currently offers a dividend yield of 8.5%. So if I invest £10,000 in it today and reinvest the dividends annually with the same assumptions I used above, after 20 years I ought to own over £51,000 worth of Imperial shares. They should produce an annual dividend income of over £4,300.
It might not happen, of course. Declining cigarette sales could hurt Imperial’s profits and force it to reduce or cancel its dividend. But if the share continues to pay out its current dividend and holds its price, owning Imperial Brands could help me retire early by reaching my financial goals sooner.
As I own it along with various other high yielders, I may be able to bring forward retirement even more!
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Christopher Ruane owns shares in Imperial Brands. The Fintech Zoom UK has recommended Imperial Brands. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Fintech Zoom we believe that considering a diverse range of insights makes us better investors.