How to create a second retirement fund

For most of us, saving for retirement comes in two parts. There's the years of working to build a pot of money. Then, when you retire, you have to turn this pot into an income to live on. Traditionally, the way to do this is to buy an annuity an income for life with your pension pot.

These can be good if you get a decent rate and you live long enough. But it makes sense to have back-up. This is where an individual savings account (Isa) is very handy. Unlike a pension, you don't get tax relief on the money you put into an Isa. But once it's in there, any money you withdraw is free of tax. So all you need is to find a cheap and effective strategy that allows you to build up your Isa savings, then pays a decent tax-free income when you need it. Thankfully, one exists it's called dividend compound investing'.

Dividends matter

The great thing about dividends is that, unlike a paper gain from a rising share price, once paid they can't be taken away. Dividends are real, tangible returns, which are independent of the regular ups and downs of the stock market. Getting a large chunk of your returns in this way may not help you to get rich quick, but you will probably have a lot less worry.

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The power of compound interest

Say you invest £10,000 in Bob's Biscuits. You pay £1 for each share, at an annual dividend of 4p or a yield of 4%. For the next 20 years, the share price of Bob's Biscuits stays at £1 and the dividend at 4p. Every year you collect a dividend of £400 (10,000 shares paying 4p each). After 20 years your investment is still worth £10,000 and you have collected £8,000 of dividend income (20 years of £400).

But what if you had reinvested your dividends in more shares instead? After 20 years, your investment would be worth £21,911 in total. That's 21.7% more than if you had taken the income every year, and it would be paying you an annual income of £843 more than double the first example.

But the real value of dividend compounding comes when you have a company that can grow its dividend payout every year. You invest £10,000 in Fred's Fizzy Drinks at £1 a share, and get the same 4p dividend as with Bob's Biscuits. Fred's Fizzy Drinks is much more successful and grows its dividend by 4% a year. The stock market continues to value the shares at a 4% dividend yield, which means that the share price grows at 4% a year too (so that the dividend yield remains static, even as the dividend rises).

After 20 years, 10,000 shares are worth £21,068 (plus £11,911 in dividends received over the years), and pay an annual income of £843. But reinvesting the dividends would give an investment value of £46,164 40% more than the alternative capable of paying an income of £1,776.

The key to success here is time. The longer you leave the dividends to compound, the better. So how do you build your own fund? You could buy an equity income fund and reinvest the dividends. But this would cost you a large chunk of your savings in fees. We look at a better way to do it below.

Rebuilding your portfolio

Above is an example of a five share portfolio with £5,000 invested in each company on 1 September 2003, with all dividends reinvested and valued again on 5 September 2013. As you can see, some shares do better than others. But the approach can work well.

Indeed, £4,219 of annual income for an initial cost of £25,000 is an income return of nearly 17%. But remember, stocks with very high yields can be risky. Choose businesses that are able to keep paying dividends backed by cash flow and high levels of dividend cover. Get this right and you don't need to worry too much about share prices. In fact, you will learn to like falling prices, as your dividend income will buy more shares and boost your long-term returns.