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How I’d invest for retirement income of £2,000 each month

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A lot of people buy shares for a very specific reason. They want to invest for retirement. The hope is that, over the course of decades, the value of a portfolio will grow and, in retirement, dividends can provide regular income.

To try and achieve that goal, I would use three straightforward but powerful investing principles.

Benefit from compounding

Dividends could certainly be a useful source of regular income when I retire. But if I earn them now, should I spend them, or simply reinvest them in my retirement portfolio?

The difference in long-term wealth creation can be dramatic. Imagine that I invest for retirement by setting up a share portfolio worth £100,000 today that generates an average dividend yield of 5%. If I did not invest any more money for 20 years and spent the annual dividends of £5,000, I would end up two decades from now with a £100,000 portfolio, if share prices were flat.

But what if I reinvested the dividends and otherwise did exactly the same? In 20 years, my portfolio would be worth £271,000. That in itself would be generating over £1,000 in monthly dividends.

That is because of the miracle of compounding. Compounding dividends while I work is a powerful way to increase my monthly income when I retire.

Focus on great quality companies

In the example above, I used a 5% average dividend yield. I think that is achievable while investing in blue-chip FTSE 100 companies right now.

The example would be even more dramatic with higher yielding shares. But a key principle I adopt when I invest for retirement (or indeed any purpose) is never to chase high yields unless it is accompanied by high quality. In other words, I focus first on finding businesses I think have solid long-term business prospects. Only then do I start to look at their share price and dividend yield.

Retirement planning is a long-term activity. Just because a share pays a high dividend now does not mean it will do so decades from now, or even next year. So I hunt for companies with business models I reckon can benefit from resilient demand that also have strong competitive advantages.

Never too early to invest for retirement

If I did find such companies I might be able to make the £100,000 in my example above work harder to fund my retirement. I think making my money work harder for me is more attractive than me having to work harder for money before I retire!

For example, if I invested an average dividend yield of 6.6% on my £100,000 for the same period of 20 years, I would then be able to have a dividend income slightly above £2,000 a month. Shares such as Legal & General currently trade with a yield over 6.6% and I could build a diversified portfolio of them.

But even with a lower yield, or indeed less money to begin with, I could hopefully still get to my £2,000 target of monthly retirement income if I had a long enough timeframe. The more years I have before retirement, the more powerful the effect of compounding, no matter how much I am investing.

It may still seem a lifetime away, but I think it is never too early to invest for retirement.