Liability matching: How to choose the right investments

Are you investing based on your future liabilities?

Having the luxury of a 20-year time horizon lets you take risks with your investments. We know that time in the market is more important than timing the market.

But what about those goals in 5 or 10 years’ time? How do you invest to ensure you don’t fall behind by then?

The concept of asset-liability matching is not the most exciting part of finance.

But it makes investing more predictable and reduces behavioural mistakes.

What is liability matching?

The idea is simple.

We all have needs and wants in life. Some are short-term, like buying a house in 3 years. Others are long-term like retiring in 15 years.

With liability matching, you buy certain financial assets to cover certain future liabilities. Those investments should match the timeframe of your goals.

For example, if you plan to buy your first home in 2 years, you should not be investing the deposit in the stock market. You risk having half the deposit in 2 years, which can easily happen.

On the other hand, if you plan to send the kids to college in 10 years, you better make your money work in some way. Otherwise, it will be a lot harder to save because of inflation.

But choosing the right assets for the timeframe gets tricky.

Some assets, like bonds, are very predictable. A government bond with a 5-year duration does what it says on the tin.

If it’s yielding 2% per year, that’s what you will get if you buy it now and keep it for 5 years. Same for bond funds with the same duration.

But other investments do not have a coupon. So how do you quantify the duration of shares or property?

If you could do that with certainty, then investing becomes a lot more straightforward. Just match the investment assets with your personal liabilities.

I know… Plans change and we don’t live in a perfect world. But more on that later.

All Duration Investing

My eye caught a paper this week from Cullen Roche who I really like reading.

He quantified the “duration” of different assets so that we can match them with our liabilities.

Investing can be more predictable by building an ‘All duration’ portfolio according to our needs.

This reduces behavioural mistakes and avoids principal loss.

Cullen writes:

Investors too often treat long-term assets like they are short-term investments and in doing so increase taxes, fees and behavioural mistakes. These frictions can be mitigated or even eliminated when the proper time horizon is applied to these specific asset classes.

But how do you quantify the ‘duration’ of an investment?

Here’s how they do it:

You find their break-even point after a decline.

In other words, if your investment is down, how long can you wait until you get back to even?

For example, if you invest £10,000, and the market declines, how long does it take for you to get back to the same amount?

Of course, there is inflation. So the same amount in 5 years won’t buy you the same stuff. So the break-even final balance needs to be higher to factor that in.

Here are the implied durations of different asset classes, which include inflation.

asset class durations
It’s all in US lingo.  Anything starting with T- means Treasury – backed by the US government. Here is a break down.
T-Bills = 3-month gov bonds.
2 Yr T-Note & ST IG = 2-year government bonds and short-term investment grade bonds (could be both corporate and government)
Bond Aggregate – a mix of bonds based on the Bloomberg Barclays Bond Aggregate Index. The UK ETFs (iShares, Vanguard) have an effective duration of around 7 years.
T-Note = 10 year Government bond, Muni = municipal bonds (only US), HY = High yield bonds
60/40 = 60% stocks 40% bonds
Global Equities = A world index fund
T-Bonds = 20 year (long) Gov bonds

Short-term goals need high nominal certainty. Inflation is less of a concern. You want the money to be exactly the amount you need.

With short-term instruments come low returns.

For longer goals, we want a different type of certainty. The certainty that we will beat inflation and grow our pot. This comes at the cost of stability in the short term.

Equities, REITs and corporate bonds serve this purpose.

Holding them for their right duration though makes them both stable and worth considering.

There is no free lunch. We want to beat inflation and accept that the road will be bumpier.

At the very end of the spectrum, you can have a few assets with low after-inflation returns or some asymmetric payoff. Like gold, long-term bonds, commodities and life insurance.

In terms of insurance (or dare I say crypto) you pay some money for a low chance of a big payoff (hopefully not needed!). For example, if something bad happens to you then you and your family get a big check.

Bell curve liability matching

I certainly find the 17-year global equities duration too conservative.

In other words, if I only invested in equities, my goals should better be at least 17 years away.

Not sure about the exact calculations they used for global equities. But at its worst, the UK stock market, for instance, took 11 years to recover from the 72-74′ market crash, if you factor in inflation too.

The US took 13 years to recover after the Dotcom bust (2000).

Of course, even in this worst-case scenario, investing regularly would shorten the time to break even.

On average, the bear market recovery time, adjusting for inflation takes 4.5 years.

Not all crashes are flash-ones, like Covid-2020!

Being Practical

I find the asset-liability matching concept very useful because it’s practical.

Once you apply it to specific goals you let the market do the work.

If history is any guide, you will reach your goals without falling behind due to behavioural mistakes.

You know that by holding the right asset for its duration, you will most likely get your money back and then some.

I’d regret more not being able to send my kid to uni than having underperformed the S&P 500. So regret minimisation beats returns maximization in my book.

Of course, there’s always a risk. But risk cannot be removed.

Imagine holding cash instead of gold for 28 years.

Depending on the timeframe, cash and bonds can be riskier!

This bucketing approach to financial planning can be applied anytime in your lifetime.

  • Big trip in 2 years -> Savings account and short-term UK bonds
  • Buy a house in 6 years -> Bong Aggregate bonds
  • Kids Uni in 10 years -> 60/40 portfolio
  • Retirement in 20 years -> World equity fund

And the opposite is true. Why keep money in cash for 5-years and risk a -30% loss of purchasing power by then? When you can earn a guaranteed 15% by using a bond aggregate fund?

Asset-liability matching is used more heavily in retirement. You can build a “bond ladder” by holding individual bonds to maturity to support retirement expenses.

This chart from Fidelity explains it well (US but relevant).

liability matching with bond ladder

As duration increases, typically the yield is higher but you have to wait for a longer time.

You can of course sell it earlier, but depending on what interest rates have done you might not get more than you invested.

Man plans, and god laughs

With liability matching, and with investing in general, you need to know your goals upfront.

This is not easy and as humans, we sometimes don’t know what we want.

Also, life is full of change.

This doesn’t mean we cannot plan. We just need to re-assess when things change.

Otherwise, we risk being in an analysis-paralysis state. Always in cash.

Perfect is the enemy of good.

If you are still in the accumulation phase, one advantage is that you regularly invest. So your new money can steer the ship in the right direction, as plans change.

Pension funds do that automatically with your retirement. They know your target date and drop the risk as you age.

Technically you can even simplify the whole process by using target-date funds for different goals.

These are funds are designed to automatically decrease risk as you approach your goal date. Say you want to retire in 13 years, pick the 2035 target-date fund.

Vanguard’s target retirement 2035 fund, in 2022 holds 68% shares and 32% bonds. In 3 years’ time, so 10 years away from the goal, this would be very close to a 60/40 portfolio.

Coincidentally, this portfolio is very similar to Cullen’s duration for a 10-year goal.

Vanguard's target-date 2035 fund
Vanguard’s target-date 2035 fund

Hopefully, by applying a duration to our assets we can better match our liabilities.

All duration investing should not be confused with the All Weather Portfolio (UK version).

All Weather is an option that is expected to provide some returns under all economic conditions! Read the link for more.

Question to you: How do you match your liabilities with your investments?

Do you tie assets to specific goals or just take a more conservative approach (say 60/40) for all your portfolio combined?

Thanks for reading!

Share this article:

Share on facebook
Share on twitter
Share on pinterest
Share on whatsapp

Join the Newsletter

Every 2 weeks, I send a handwritten email with honest, valuable content.
No spam, ever.

    We respect your privacy. Unsubscribe at any time.

    You may also like...

    2 thoughts on “Liability matching: How to choose the right investments”

    1. Hi Michael, interesting article. I like the idea of using a number of target date funds with different durations for different goals. Simple and easy to manage. Something I will be looking into. Thanks.


    Leave a comment