I recently read that “passive income is the fuel that powers your dreams, giving you the freedom to pursue your passions and live your life on your own terms”. I have no idea who came up with this quote, but I hope they dream well and are in a position to spend their time doing something fulfilling.

Another investing concept that gets a good press is compounding. In the case of income stocks, this is the act of reinvesting dividends to buy more shares, generating an ever increasing level of return. This has been described as the eighth wonder of the world.

Just imagine how happy we could be by combining the two! Well, that’s what I try and do.

Now, I must be honest. I still have to work for a living and I’d love to have more freedom to do what I want. But I do have a steady stream of passive income that I’m reinvesting with a view to having a more comfortable retirement.

Take two

If I were to start my investing journey all over again, I’d put a relatively modest amount (say £100) into UK income stocks. If I then received dividend payouts of 5.9% a year — payable two-thirds/one-third in January and July, respectively — my hypothetical sum would grow to £67,248 after 25 years.

At this point, my shareholding would be generating income of £3,967 a year.

Readers may be wondering why I’ve chosen such specific numbers. Well, that’s because National Grid (LSE:NG.) presently offers a 5.9% yield and pays a dividend twice a year.

And it’s a share that has a long track record of increasing its payout.

My example assumes zero growth in its dividend. However, factoring in an increase of 3.6% a year — the company’s average annual increase over the past five years — would increase my investment pot to £131,731. This could give me an annual passive income of £7,772.

Remember, there could be some capital growth too.

Caution

Of course, the stock price could fall. And dividends are never guaranteed. But this example highlights the potential long-term gains achievable from picking a steady and reliable income stock.

National Grid is able to pay a generous dividend because its earnings are reasonably secure. It operates in a regulated industry, which means as long as it keeps the lights on (literally), it will be able to achieve a pre-agreed level of return.

Because of this its share price performance tends to be unspectacular. This — along with the fact that it’s the UK’s 13th-largest listed company — is why I describe it as a sleepy giant. I think there’s always room for this type of stock in a well-balanced portfolio.

But there are a couple of things that could threaten its ability to maintain its healthy dividend.

Although it doesn’t face any competition it must meet its regulatory obligations. This requires huge capital expenditure.

It surprised shareholders in May by asking them for more money. Due to the company’s large borrowings, perhaps its directors felt they had no alternative other than to approach its owners for additional cash. I wonder if the terms offered by lenders were unfavourable.

However, despite these challenges, the next time I’m in a position to invest I’m going to seriously consider taking a stake.