Investment Insider: Income and capital protection takes the long view

Would you be prepared to swap your pension pot of £100,000 for a constant, unchanging income of about £5,000 for the rest of your life? That is what insurers are offering 60-year-olds if they were to buy a level annuity today.

Bearing in mind that £5,000 may only have the purchasing power of £2,500 after about a decade, you may want to consider an alternative. What can we do to protect our capital while generating increasing income?

Yield on cost can hold the key and is the main plank of my investing strategy. I like to buy dividend-paying shares when they are fairly valued. They may not be the highest yielders but I intend to hold them for the long term to collect their growing dividends. But to work, you need patience and an almost totally disregard of the share price after you have made your investment.

Consider British American Tobacco, which cost around 800p to buy in 2004. Then, the dividend payout was 39p a share – a yield of 4.8 per cent. Today, shares that now cost 3,120p paid a dividend of 127p, a 4 per cent yield. This may not seem overly generous unless you bought the shares eight years ago. The dividend payout of 127p on the original cost is almost 16 per cent. Put another way, the 15 per cent rise in annual payouts has pushed up the yield on cost from 4.8 per cent in 2004 to 16 per cent in 2011.

Other companies that have gradually ratcheted up dividends include Vodafone, GlaxoSmithKline and Unilever. It doesn't necessarily follow that the share price must track the dividends higher. In the case of GSK, its shares are roughly the same now as 10 years ago. What's more, the shares fell below 1,000p in 2008, so investors could have bought them more cheaply, reducing the overall cost of investment, which in turn improves the yield on cost.

Of course, things can still go wrong which is why it is important to build a wide portfolio of shares to help reduce risk.

David Kuo is a director of financial website fool.co.uk