page_title: Dedicated portfolio theory
section_title: Example of a dedicated portfolio
hierarchical_section_title: Dedicated portfolio theory / Example of a dedicated portfolio
caption_attribution_description: English: Asset Dedication - Wikipedia - Dedicated Portfolio Theory - Table 3.1
context_page_description: Dedicated portfolio theory, in finance, deals with the characteristics and features of a portfolio built to generate a predictable stream of future cash inflows. This is achieved by purchasing bonds and/or other fixed income securities that can and usually are held to maturity to generate this predictable stream from the coupon interest and/or the repayment of the face value of each bond when it matures. The goal is for the stream of cash inflows to exactly match the timing of a predictable stream of cash outflows due to future liabilities. For this reason it is sometimes called cash matching, or liability-driven investing. Determining the least expensive collection of bonds in the right quantities with the right maturities to match the cash flows is an analytical challenge that requires some degree of mathematical sophistication. College level textbooks typically cover the idea of “dedicated portfolios” or “dedicated bond portfolios” in their chapters devoted to the uses of fixed income securities.
context_section_description: While most of the original work on dedicated portfolios was done for large institutional investors such as pension funds, the most recent applications have been in personal investing. This example is a couple who wants to retire this year (call it 20XY, such as 2018) and has already set aside cash to cover their expenses. Social security will supply some income, but the rest will have to come from their portfolio. They have accumulated a retirement portfolio worth $2,000,000 in addition to this year's expenses. Typically, retirement portfolios have a higher percentage of bonds in their portfolio than portfolios owned by younger people who are not yet approaching retirement. Probably the most common retirement portfolio would be a 60/40 stock/bond allocation compared to an 80/20 or 90/10 stock/bond allocation for younger investors. Following a common rule of thumb for retirement withdrawal rates to make a retirement portfolio last at least 30 years, they should withdraw no more than 5 percent from their portfolio next year ($100,000). They can increase it each year by the amount of the previous year's inflation. To be conservative, they will plan for an annual inflation rate of 3 percent (they may not spend it, but want the protection just in case). Table 1, lists the projected stream of withdrawals. These withdrawals represent the yearly “income” the couple needs for living expenses over their first eight years of retirement. Note that the total cash flow needed over the entire eight years sums to $889,234.
  Table 2 shows series of bonds and CDs with staggered maturities whose coupon and principal payments will match the stream of income shown in the Target Cash Flows column in Table 1 (rates are fictitious for this example). The cash flow generated by the portfolio for the first year would be $100,380. This consists of the principal of the bond maturing on February 15 next year plus the coupon interest payments flowing from all the other bonds. The same would be true for the following year and every year thereafter. The total cash flows generated over the eight years sum to $889,350, compared to the target cash flow sum of $889,234, a difference of only $116. As with the first year, the cash flows are very close to the target cash flows needed for each year. The match cannot be perfect because bonds must usually be purchased in denominations of $1,000 (municipal bonds in denominations of $5,000). However, with the use of fairly sophisticated mathematical optimization techniques, correlations of 99 percent or better can usually be obtained. These techniques also determine which bonds to buy so as to minimize the cost of meeting the cash flows, which in this example is $747,325. Note that in this example, the bonds all mature on February 15, the middle of the first quarter. Other dates may be used, of course, such as the anniversary date of the portfolio's implementation.
  This would be the initial dedicated portfolio for the couple. But they hopefully have a lifetime financial plan designed to last 30 or 40 years. Over time, that means the portfolio will need to be updated or rolled forward as each year passes to maintain the same 8-year time horizon. The time horizon could be extended by adding another bond with an 8-year maturity or the equivalent. Extending on a regular basis could therefore provide a perpetual series of 8-year horizons of protected income over the investor's entire lifetime and become the equivalent of a self-annuity. Whether the replenishment occurs every year automatically or only if other criteria are met would depend on the level of sophistication of the investor or advisor.
  The 8 years of bonds can be thought of an “income portfolio” because it is dedicated to providing a predictable steam of income for the next 8 years. The rest of the portfolio can be thought of as a “growth portfolio” because it would be dedicated to providing the growth needed to replenish the income portfolio. The growth portfolio would presumably be invested in equities to achieve sufficient growth.
  Recent research has sough
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