10 shares to give you a £10,000 annual income

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Savers gave up on current accounts for generating income years ago, ever since the financial crash triggered a plunge in interest rates to just 0.5% in 2009.

Dividend-paying equities emerged as a favoured alternative, supported by rule changes in 2014 that made investing in an ISA more attractive.

This got us thinking about how much an investor would need to generate an income of £10,000 a year from an equity portfolio. A year ago, to maximise certainty and limit risk, we picked eight blue-chips with a track record of regular and sustainable dividends.

A pair of speculative high-yielding shares completed a basket of 10 shares, beefing up potential returns in exchange for a little extra risk. We found that an investment of just over £182,000 would produce the required income.

Last year's performance

Despite frightening volatility and various threats to company earnings in 2015, we did pretty well. Of the £10,000 income we wanted, we generated £9,788. However, one of our picks has yet to pay the final dividend to be factored into our calculations; once that is included, the total is £9,914.

Of our 10 constituents, most fulfilled their dividend promise. Shell, HSBC and BHP Billiton all pay dividends in dollars and these were lower than expected, partly because we converted the dollar dividend estimates to sterling in January 2015 when the exchange rate was about $1.51 to the pound. Over the summer, it nudged $1.59.

Imperial Tobacco was the outstanding performer, in terms of both income and capital return. Admittedly, we had some help, as Imperial began paying quarterly dividends in 2015. That meant we benefited from a third-quarter dividend of 49.1p. Previously, this would have been included in a final payout that historically went ex-dividend in mid-January. The share price rocketed by 24% too.

Manchester-based Entu, a supplier of windows, doors, solar panels and energy efficiency products, also did well. It announced a special dividend of 1.5p followed by an interim dividend of 2.67p in August.

Unfortunately, problems at the solar division triggered a profits warning, and the 8p a share annual ordinary dividend promised at IPO in late 2014 will now be more like 5.34p. Assuming that's confirmed in full-year results due at the end of January, the yield is still a respectable 6.5%.

Long-term commitment

True, our portfolio lost almost £14,000, or 7.6% of its capital value, but the FTSE 100 index is down more than 9% over the year to 7 January*.

Remember, too, that buying an income portfolio is typically a long-term commitment, and this one-year experiment is unlikely to be indicative of future performance. Adding the income received back to the remaining capital leaves us down around £4,000, but with the objective of income generation intact.

However, looking at prospects for 2016, the hunt for yield is at a pivotal point. The risk to both dividends and capital is greater now than a year ago. A marked economic slowdown in China has already caused markets to tumble in 2016, and tension in the Middle East is always a worry.

Interest rates may be on the way up, and equities are not obviously cheap, yet companies are handing more of their profits to shareholders via dividends than at any time in the past few decades. Indeed, dividend cover - the number of times a company can pay the dividend out of annual earnings - currently stands at just 1.6 times.

Struggling miners Glencore and Anglo American, supermarkets Tesco and Morrisons, and more recently Standard Chartered Bank, have all either cut their dividend or scrapped it entirely. Suddenly there's a dearth of reliable high-yield stocks, although the fall in share prices means the average yield is higher now.

Picking 10 companies certain enough to deliver annual dividend income of £10,000 is less straightforward in 2016, but we can build the portfolio with just over £176,000 this year - £6,000 less than in 2015.

Portfolio tweaks

The first holding to be jettisoned from the portfolio is BHP Billiton. Profits are already tipped to more than halve this year, and the miner faces possible fines of billions of dollars after a tailings dam at one of its mines in Brazil collapsed, killing at least 17 people.

Optimistic management increased the interim dividend by 5%, then kept the final divided flat. BHP remains committed to a "progressive dividend policy through the cycle", but a dividend yield of more than 10% suggests it is only a matter of time before the payout disappears, possibly in its half-year results in February.

There's no place for water utility Severn Trent this year, either. It was forced to drop its commitment to above-inflation dividend increases following regulator Ofwat's latest pricing review, and the annual dividend will now grow at no less than the retail prices index until 2020.

Yes, a prospective yield of around 3.8% is decent enough, but it is less than the current FTSE 100 yield, and we can do better.

Housebuilder Barratt Developments currently offers a forward yield of 5.2% covered 1.8 times by forecast earnings. The share has been a solid performer for a number of years, and the housing boom, the government's Help to Buy scheme and the ongoing housing shortage should continue to underpin reasonable growth. A forward price/earnings (PE) ratio of 11 times is largely in line with the sector.

Political and economic instability in South Africa rule out Old Mutual as a new holding, but rival life insurer Legal & General is likely to cause fewer sleepless nights and yields a healthy 5.4%. This impressive asset management business, the 15th largest in the world, should continue to drive strong earnings growth this year.

We've found a company able to fill the void left by both last year's speculative income plays. Entu's decision to cut its dividend created too much uncertainty around future payouts.

Meanwhile, online gaming firm GVC Holdings' bid for bwin.party digital entertainment is sound, but a condition of the €400 million (£277 million) of debt financing needed to pull off the deal is a suspension of the dividend for 2016.

As a reliable replacement, we need look no further than support services and construction firm Interserve.

It works for the government, London Underground, Middle East oil companies and on huge infrastructure projects here and abroad. It has been making big profits, and has increased its dividend every year since at least 2003.

Despite sub-contractor insolvencies hitting the UK construction division, full-year results should still meet expectations. A dividend more than twice covered by profits generates a yield of 4.8%, and a p/e ratio of just eight times earnings looks cheap.

Solid stock picks

Of the 10 companies we picked last year, six make it into the 2016 portfolio. How could we leave out our best performer in 2015 - Imperial Tobacco?

Despite a massive surge in the share price, the tobacco major still offers a prospective yield of 4.4%, and persistent speculation about a possible bid from British American Tobacco or Japan Tobacco should support the current valuation.

Perhaps surprisingly, Shell is also in the portfolio. Oil prices may have fallen again to below $35 a barrel now, but the oil major is selling assets, and cost cuts are being tipped to exceed targets. The acquisition of BG should underpin the payout over the longer term, but Shell has already promised to pay $1.88 a share for 2015 and 2016. That gives a yield of almost 9%.

GlaxoSmithKline still expects to pay an annual ordinary dividend of 80p until 2017. And there will be a special dividend in 2016 as the drug giant hands back £1 billion following the asset swap with Switzerland's Novartis. It originally planned to return £4 billion, but investors owning Glaxo shares on 18 February will still get 20p a share.

Elsewhere, an improving outlook for defence spending is great news for BAE Systems. There are uncertainties around Eurofighter orders from Saudi Arabia, but the company will get a piece of the massive US military budget and work from the Ministry of Defence. BAE shares trade at a big discount to the sector and pay twice the average dividend.

HSBC has been through the mill, and Far East and emerging markets business will likely remain tough. The bank will have to keep cutting costs to offset pressure on the top line, but the dividend is safe for now.

Growing the dividend "at least" in line with RPI inflation "for the foreseeable future" gets National Grid the nod. That promise will be backed by cash from the sale of most of its UK gas distribution business, which looks after 82,000 miles of pipeline and delivers gas to around 11 million customers.

Halfords has had a rough ride since last summer. Wet weather hit bike sales, forcing a profits warning. Still, its shares, at their lowest since 2013, look cheap. Heavy spending on a new customer-focused strategy will limit short-term growth, but the dividend is generous and twice covered by earnings.

*Figures correct at time of writing.