Five Percent Rule
An aggressive modification of the Four Percent Rule for people with a higher risk appetite or a shorter time horizon.
An aggressive modification of the Four Percent Rule for people with a higher risk appetite or a shorter time horizon.
The Five Percent Rule withdraws a larger amount of money from your portfolio per year than most retirement strategies.
This provides you with a higher yearly budget, but at the cost of a shorter time horizon.
With a traditional 4% withdrawal rate, a $1,000,000 portfolio would have you withdraw $40,000 the first year, but the 5% Rule, allows you to withdraw $50,000 in the first year.
This higher yearly budget comes at the cost of depleting your resources sooner.
So, instead of using this strategy as a long term strategy, it is better used as a short term bridge to get you from one phase of your financial life to another. This could be in the form of living off of your savings until another income stream kicks in, like social security or a pension.
This is the most important questions involved in any retirement strategy, especially when you choose a highly aggressive strategy like the Five Percent Rule.
The following chart shows the likelihood of the strategy working across real historical time periods (and also shows how it would perform with different withdrawal rates for comparison):
| Durations | ||||||
| 10 years | 20 years | 30 years | 40 years | 50 years | ||
|---|---|---|---|---|---|---|
| Withdrawal Rates | 3% | 100% 93/93 | 100% 83/83 | 100% 73/73 | 100% 63/63 | 100% 53/53 |
| 3.5% | 100% 93/93 | 100% 83/83 | 100% 73/73 | 100% 63/63 | 96% 51/53 | |
| 4% | 100% 93/93 | 100% 83/83 | 100% 73/73 | 89% 56/63 | 75% 40/53 | |
| 4.5% | 100% 93/93 | 100% 83/83 | 89% 65/73 | 67% 42/63 | 49% 26/53 | |
| 5% | 100% 93/93 | 100% 83/83 | 71% 52/73 | 51% 32/63 | 36% 19/53 | |
| 5.5% | 100% 93/93 | 90% 75/83 | 62% 45/73 | 43% 27/63 | 23% 12/53 | |
| 6% | 100% 93/93 | 78% 65/83 | 53% 39/73 | 27% 17/63 | 13% 7/53 | |
It is worth noting, for anyone considering using the Five Percent Rule, that only 52 out of the 73 historical iterations successfully lasted throughout a 30 year retirement. Unless you having a very strong reason for planning for a shorter retirement, we would highly suggest that you consider a strategy that has better than a 71% chance of surviving throughout the entire time period needed.
If you have an appetite for higher spending and are open to having a more volatile an inconsistent spending budget, then the Five Percent Rule combined with a reset threshold might be a great solution for you.
The problem with the Five Percent Rule is that its more aggressive spending results in a greater change of running out of money. By adding a reset threshold, you negate some of the risks of down years in the market cutting away at your savings.
A reset threshold will reset the 5% rate every time that the market goes low enough to hit the threshold.
For example, if your starting balance is $1,000,000 then your first withdrawal would be $50,000. If the market dips and your balance goes to $800,000 hitting your 80% bottom threshold, then your next withdrawal after hitting the threshold would be 5% of the new balance, which would be $40,000.
This cut in spending is no fun when it happens, but if you are able to readjust your lifestyle, it will allow you to lengthen the amount of time that you will be able to live off of your savings.
Withdrawal Inflation Rate Bumps
Combining a high threshold with a low inflation rate bump will make the Five Percent Rule a more conservative option for those who want to have higher spending in retirement and are okay with having to take a few spending cuts in order to maintain their desired spending.
A lower inflation rate bump will decrease the growth rate of your spending, but will help to preserve a higher balance of your savings.
This can be visualized in the calculator by opening the "Advanced Settings" section and choosing a different option for the "Withdrawal Inflation" setting.
If this plan will not last as long as other plans, then why would someone choose such an aggressive strategy?
There are multiple valid reasons why someone would choose a plan with a shorter time horizon.
For example, you could be in a transitional phase of their financial life, such as in between jobs or you could have a medical issue that will prevent you from working for a certain time period.
It could also be used as a bridge to get to an alternative sources of income in the future. For example, you may have social security of a pension that won't begin to payout until a future date. You could use the Five Percent Rule as a strategy to provide income until the alternative source of income kicks in.
Additionally, you could desire to set up a specific fund that will provide funds for certain purposes. This could be a vacation fund that will help you fund vacations for the next 20-30 years without having to provide any further deposits into the fund. Or it could be a fund that has a purpose for a family member of heir that will provide them with resources for the next few decades of their life.
If you only need your portfolio to provide income for a short time period, then the Five Percent Rule could be an effective strategy.
If you truly have a purpose for a shorter time horizon, it would be beneficial to talk to a financial advisor in order to plan what the makeup of your portfolio should be. For example, it may be wise to have a more bond heavy portfolio if you know that you will be exhausting your portfolio balance in the shorter term.
You should think very carefully before choosing such an aggressive strategy. You should not choose an aggressive strategy if you have a long time horizon or if you rely solely on the income from this plan as your sole source of income. For most people, unless you have a very clear, shorter term purpose, it would be wiser to select a more conservative strategy.
If you are concerned about running out of money too fast, then you should consider a more conservative strategy such as the Four Percent Rule or the Three Percent Rule.