Different ways to generate an income in retirement

Investments can be someone’s main source of income once they retire, swapping a salary for dividends to pay the bills. This reliance on a pension emphasises the importance of having a good spread of income-generating investments.

There’s lots to choose from, and your selection will depend on your risk appetite and time horizon, among other factors. Read on to find out more about the range of income-generating investments.

Investing in bonds

Bonds are a popular option for investors who are looking to lower their risk level while keeping investments in the market. They pay a regular income – typically once every six months – and you get back the face value of the bond when it matures.

There are two types of bonds: corporate bonds, which are loans to companies, and government bonds, such as a gilt. You can either buy these individually, or a fund will bundle them together for you. These can offer different levels of risk and yield, depending on how highly rated the issuer is.

One way that investors can choose to generate income through fixed income is by building a ‘bond ladder’. This means buying a group of bonds which all expire at different times, so you create a pathway of income. For example, you may choose to purchase 10-year, five-year, and two-year bonds. This means that you’ll be receiving interest through the payments of these bonds and get an additional boost when the bond gets to its intended time, and your investment is returned to you.

If you’d rather avoid the hassle of choosing individual bonds, you can simply invest in a bond fund. Some funds restrict themselves to either corporate or government bonds, while others known as strategic bond funds will have a mixture of them.

Generating an income from stocks and shares

Many companies will pay dividends to shareholders on a quarterly or half-yearly basis. As an example, let’s say you have £1,000 invested in Company X and it has a 5% dividend yield. That means you will collect £50 in dividends in a year.

As with any investment, it's important to look at a range of factors when picking stocks rather than simply going for the ones with the highest dividend yields. You need to make sure a company has the financial strength to sustain dividends, as well as taking a view whether the shares are cheap, fair value or expensive, and considering its strategy and any competitive threats.

Investing in equity income funds

If you don’t want to invest in an individual share, there is a wide range of funds and investment trusts that provide exposure to a diverse range of companies.

Equity income funds will have a portfolio of stocks typically across a variety of industries. Some will focus on a certain geography, others will look around the world for opportunities.

Income funds come in many shapes and sizes, allowing you to select different risk levels, as well as different growth prospects. Investors can peruse different income funds using AJ Bell’s fund screener tool, to get further details on yield and fund performance, among other attributes.

It’s worth noting that most income funds come in two versions. Select the one with ‘Inc’ in the title to collect income as cash or the one with ‘Acc’ in the title if you want dividends automatically reinvested.

Sectors with generous dividends

Certain sectors have a reputation for paying generous dividends, such as property, renewable energy and infrastructure, and these are well served by investment trusts. It’s possible to get 8% yield or higher from trusts in this space. Our investment trust screener tool helps with your research.

It is important to keep an eye on what funds and trusts have to offer investors apart from dividend yield, and if they fit with your investment goals.

Investors can also get a combination of equity and bond exposure through investing in a multi-asset fund. This can offer a more diversified portfolio exposure while still generating an income.

Enhanced income funds

For those looking for a larger take-home pay, enhanced income funds can offer investor payouts that sometimes even outstrip what the dividend payments are worth. However, they may not be for all investors, because of higher fees and a complicated process to create their returns.

In addition to running like a regular income fund, where the managers hold companies that pay out dividends, these funds aim to create additional returns through selling call options on the stocks.

Here’s how call options work: A seller (which in this case, is the enhanced income fund), offers a contract to a third-party, which gives them the option (but not obligation) to purchase a stock for a pre-determined price on a set date. In the meantime, the buyer pays a fee to the seller to have this ability.

If the price of the stock rises significantly, the buyer will likely be able to make money off the deal, because the stock is now worth more than the pre-determined price. But if a stock price does not move to the level the buyer wanted, the fund will still collect a fee linked to the option, and that’s used to top up their dividend payment to investors.

This process can be difficult to get your head around, so it's important to make sure it's something you are comfortable with before diving in.

Companies with a long history of dividend growth

Sometimes it is not always about the headline yield, but rather the ability to tap into a growing stream of dividends. Cash savings can be eroded by inflation, yet investments can often beat inflation, meaning your money goes further.

Certain income funds have ‘Dividend Aristocrat’ in the name, which indicates they invest in companies that have increased their dividends for 25 years or more.

Alternatively, you could look for ‘Dividend Heroes’ which are investment trusts that have a record of raising their dividend each year for 20 years or more. The Association of Investment Companies provides a list of dividend heroes for investors.

Income and growth funds

If you are still comfortable taking some risk in drawdown and would like the chance for more growth in your pension pot, you can opt for an income and growth fund. These portfolios aim both to pay a dividend and find stocks that they believe have potential for larger share price increases.

While the dividend yield might be lower than a typical income fund, they can offer a blended approach that can help your pension last for longer, even when you’ve begun to draw on it.