Liability matching

Liability matching strategies allow an investor planning for retirement or other goals to meet specific financial targets with near certainty.Pfau W, Cooper J (2014) The Yin and Yang of Retirement Income Philosophies, report for Challenger Limited, 28 p. Matching strategies only work with fixed income and insurance products such as annuities. There must be a known maturity date for the asset so the timing of the asset and liability can be matched.Bodie (2006) A Note on Economic Principles and Financial Literacy. Networks Financial Institute Policy Brief No. 2006-PB-07. Available at SSRN, viewed March 31, 2018.
Risk is managed in life-cycle finance using hedging, insuring, and diversifying.Hogan PH (2007) Life-Cycle Investing Is Rolling Our Way Journal of Financial Planning, May 2007, p. 46-54, viewed March 31, 2018.Merton RC (2003) Thoughts on the Future: Theory and Practice in Investment Management, Financial Analysts Journal, v. 59, p. 17-23, viewed March 31, 2018. Bodie Z (2002) Life-Cycle Finance in Theory and in Practice. Boston University School of Management Working Paper #2002-02. Available on SSRN, viewed March 31, 2018. Important minimum goals are met by hedging and insuring. Higher aspirational goals are met by diversifying, i.e. investing in a mixture of safe and risky assets. 
Matching strategies are very safe, but offer little or no upside potential.Merton RC (2014) The Crisis in Retirement Planning. Harvard Business Review, July–August 2014 Issue Diversification strategies are risky, but offer higher expected returns and upside potential. An important reason that matching strategies are safer is because typically they use hedging to mitigate risk. By hedging risk you are protected against both non-market and market (systemic) risk. In contrast, diversification can only protect you against non-market risk.
In the context of retirement planning, the 'liability' that needs matching is a retirement income floor (see Dual Budget model), indexed for inflation.Bodie Z, Taqqu R (2011) Risk Less and Prosper: Your Guide to Safer Investing, Wiley, 196 p. ISNB 978-1-118-01430-1. In this context, a synonym for liability matching is "retirement income protection" and forms part of the safety-first approach to retirement planning.
==Safety-first==
Guaranteed income streams such as Old Age Security (OAS), Canada Pension Plan (CPP), Québec Pension Plan (QPP), and defined benefit pensions (which are not all inflation indexed), if applicable, contribute to the retirement income floor. In a couple (as opposed to an individual living alone), these income streams can be doubled. If the total of these sources of protected income is already high enough to meet the household's essential expenses, then the investment portfolio(s) can be completely assigned to fund aspirational goals: it/they become(s) an "aspirational portfolio".
However, for many Canadians -- especially those without access to DB pensions, and/or who live alone --, OAS and CPP/QPP will not be enough to reach the retirement income floor. The missing portion can be obtained through the liability matching (income protection) approaches described in this article. Those include delaying OAS and CPP/QPP to increase the amounts; a liability matching portfolio; annuities; or a combination of methods. This is what Milevsky and Macqueen call "pensionizing your nest egg".Milevsky MA, Macqueen A (2010) Pensionize Your Nest Egg: How to Use Product Allocation to Create a Guaranteed Income for Life, Wiley, ISNB 978-047068099 Whatever is left of the portfolio after the retirement income floor has been secured goes to the aspirational portfolio.
Several income protection options are examined in the following sections. All of them avoid sequence-of-returns risk, since no stocks are involved in liability matching strategies. Inflation risk and longevity risk are addressed to variable degrees depending on the method(s) chosen.
==Delaying government pensions and benefits==
OAS and CPP/QPP have life annuity-like characteristics: they provide guaranteed income for life. Furthermore, these income streams are indexed to inflation, unlike most commercial life annuities purchased from life insurance companies. Retirees can significantly increase the amounts received from OAS and CPP/QPP by delaying their start, perhaps up to age 70: this is conceptually equivalent to buying an inflation-indexed annuity, the perfect hedge for longevity risk.MacDonald BJ (2020) Get the Most from the Canada & Quebec Pension Plans by Delaying Benefits: The Substantial (and Unrecognized) Value of Waiting to Claim CPP/QPP Benefits. National Institute on Ageing, Ryerson University, 70 p. But by delaying government pensions and benefits, the retiree does not have to hand over assets to a private annuity provider (life insurance company), since the government is providing the enhanced income stream. 
Several authors recommend delaying OAS and/or CPP/QPP to age 70 to get higher guaranteed inflation-indexed payments at age 70, if you can afford it and expect to live long enough to recover the 5 years of lost payments between 65 and 70.John Heinzl, The boomer’s dilemma: When to start collecting CPP?, The Globe and Mail, November 6, 2015, viewed December 19, 2016Tim Cestnick, How to time the collection of CPP and OAS, The Globe and Mail, September 25, 2015, viewed April 1, 2018. For example, delaying CPP between the ages of 65 and 70 can yield an amount over 40% higher.Fred Vettese, Why you should wait until you are 70 to collect CPP benefits, National Post, October 16, 2016, viewed December 14, 2016. 
===Comparison with the annuity market===
The idea is to put enough money aside in low-risk investments and savings (bonds, GICs, cash) to bridge the 5 to 10 years-long gap until OAS and/or CPP/QPP eventually start, with higher amounts. Bridging the gap will consume a portion of the retiree’s investment portfolio, just like a commercial annuity purchase would. But delaying OAS and/or CPP/QPP is much more cost-effective than buying an annuity in the private market. MacDonald (2020) illustrates this with a hypothetical $100k life annuity purchase, the typical amount used in quotes. For a 2%-indexed life annuity -- the closest product available in the private market -- in October 2020, a 70 year-old male would have gotten about $5.3k per year in income and a female $4.7k per year. The math involved in delaying CPP from age 65 to 70 is the equivalent of getting about $9.1k a year on the hypothetical $100k annuity purchase. In other words, for a female, delaying CPP is almost twice as good as buying a private market annuity that is not even fully indexed to inflation.
For further discussion see: 
* OAS: when to Apply
* Delaying CPP
* Delaying QPP
===Example===
Taking delaying OAS as an example, to bridge the gap and provide a safe income between the ages of 65 and 70, you set aside a large enough amount to cover five years’ worth of missing OAS payments. At the beginning of 2024, the maximum yearly OAS at age 70 is about $11.6k, 36% higher than if claimed at age 65.Governement of Canada, Should you wait to start collecting Old Age Security, viewed February 2, 2024. Assume a 0% real (after inflation) return for simplicity: you need to set aside five times that amount, currently totaling about $58k. The first tranche could be in a high-interest savings account (HISA) (to cover monthly payments in the first retirement year) and the four subsequent tranches could be in GICs with the appropriate maturities (1, 2, 3, 4 years), forming a declining GIC ladder. A short term bond ETF or HISA could also be used.post, by longinvest in FWF topic "Delay OAS to 70, spend 8.8% more at 65!", April 10, 2017 Because this money is to contribute to the safe income floor, the GIC ladder could be progressively set up, initially as a rolling ladder, 5 to 10 years before retirement, using new contributions.
Similar calculations can be made for delaying CPP to age 70.post, by longinvest in FWF topic “CPP Deferral debate - Fred Vettese article discussion“ March 26, 2017
===Potential downside for couples===
In the commercial annuity market, joint annuities are available. Those annuities continue to pay, with of without reduction, as long as one member of a couple is alive. In contrast, OAS has no survivor benefit, and CPP/QPP have limited survivor benefits (depending on the situation). So the analysis of delaying OAS and CPP/QPP is more complex for couples.Financial Wisdom Forum, topic "CPP/QPP Claiming Decisions: Shifting the Paradigm on how we help Canadians", started on April 11, 2024, viewed April 16, 2024
==Using immediate fixed annuities==
Single premium immediate (life) annuities (SPIAs) guarantee at least a nominal income for life, and benefit from mortality credits.MacDonald B-J et al. (2013) Research and Reality: A Literature Review on Drawing Down Retirement Financial Savings. North American Actuarial Journal, v. 17, p. 181-215, viewed April 2, 2018.Butt A, Khemka G, Lim W, Warren G (2023) Primer on Retirement Income Strategy Design and Evaluation. Society of Actuaries Research Institute, 104 p. This means that people who die early subsidize the income of people who live longer than their life expectancies. While this might sound like a gamble, a better way to frame it is that annuities are a form of longevity insurance and are ideal to cover longevity risk. The risk of an unknown lifespan is pooled (mutualized) with other retirees.Finke M, Blanchett D (2016) An Overview of Retirement Income Strategies. Journal of Investment Consulting 17: 22-30, available at SSRN, viewed February 4, 2024.
Another factor is that non-annuitized wealth is psychologically more difficult to spend than annuitized wealth (government pensions, DB pensions, annuities); Blanchett and Finke (2021) estimate that "every $1 of assets converted to guaranteed income will result in twice the equivalent spending compared to money left invested in a portfolio".Blanchett D, Finke MS (2021) Guaranteed Income: A License to Spend, viewed February 20, 2024. They see this as "both a behavioral and a rational response to longevity risk".
SPIAs also eliminate investment risk and sequence of returns risk, on the portion of the capital used to purchase the annuity. Another advantage of SPIAs (over self-managed drawdown strategies) is preventing bad investment decisions later in life due to cognitive decline. Some retirees might potentially want more protected income (over and above essential expenses), to guarantee a decent standard of living during retirement, and may wish to use SPIAs for this purpose. 
One downside of SPIAs (among others) is that the capital won’t be available for emergencies. Annuity purchases is not reversible, partly explaining why they are not more popular. Handing all your capital over to an insurance company does not sound appealing to many people. But complete annuitization is not generally required. 
Vettese (2018)Vettese F (2018) Retirement income for life: getting more without saving more. Milner & Associates, 218 p. (ISBN 1988344050) suggests that because actual retirees do not fully increase spending along with inflation in their 70s and 80s, whereas CPP/QPP and OAS are fully indexed, the income to be generated from other sources does not have to fully indexed. He also notes that indexed annuities tend to be over-priced. He therefore recommends using immediate annuities, without any indexation. For couples, he specifically recommends a joint and survivor annuity.
Partial annuitization is possible, and it can be done in stages to preserve liquidity as long as possible. In a interview, for investors without DB pensions, Vettese recommends to annuitize 30% of one’s nest egg at 65, and another 20-30% around age 75. Annuitizing in several steps is called “laddered annuitization”.
==Combining bond ladders and annuities==
In this group of strategies, the retiree combines a self-managed liability-matching portfolio (typically a bond ladder) to provide income during during the first portion of retirement, and an annuity to provide income during the later part of retirement. The annuity can be a deferred annuity purchased upon retirement, or an immediate annuity for which the purchase is delayed.
===With a deferred annuity===
With a deferred annuity, you pay a lump sum today and get a stream of regular monthly payments in the future, starting after a specified delay. Mortality credits are higher at advanced ages, so in general, deferred annuities are cheap.
For example, you could set up a ladder of bonds to cover retirement income needs for the first 20 years, and use a deferred annuity to provide income afterwards.Shankar, S Gowri (2009) A New Strategy to Guarantee Retirement Income Using TIPS and Longevity Insurance. Financial Services Review, v. 18, no. 1, p. 53–68.Sexauer SC, Peskin WM, Cassidy D (2015) Making Retirement Income Last a Lifetime. Financial Analysts Journal, v. 68, no. 1, p. 74–84. This strategy avoids the loss of liquidity associated with immediate annuities, yet covers the longevity risk. In U.S. examples provided in the linked journal articles, the proportion of capital used to buy the deferred annuity is about 10%, and the rest goes into the bond ladder.
Buying a deferred annuity upon retirement, instead of a SPIA, keeps more money in the investor’s hands during the first part of retirement, for those who have less of a commitment orientation. Less conservative investors might even keep the non-annuitized funds in a diversified portfolio of stocks and bonds, instead of a bond ladder, although if future investment returns are bad, the investor might regret that decision.
Unfortunately, the market for advanced-life deferred annuities (ALDAs) is not yet competitive in Canada. As of late 2023, only one insurance company has started to offer them.Wealth Professional, Desjardins launches Canada's first ALDA for deferred retirement withdrawals, December 7, 2023, viewed December 10, 2023. Unless they are in a hurry, retirees may wish to wait until the market becomes more competitive, before buying an ALDA or even seriously considering this approach.
===Using SPIAs purchased later===
Instead of buying a deferred annuity upon retirement (perhaps at age 60 or 65, for example), the investor can wait to age 70 or 75, and then buy a SPIA. Meanwhile, the funds would likely sit in a bond ladder. If complete inflation protection is desired, Real Return Bonds (RRBs) and inflation-indexed life annuities would be used, in an ideal world. A strategy combining them could be as follows:
# During accumulation, build a liability-matched RRB + guaranteed investment certificate (GIC) ladder to cover the retirement income floor. Alternatively, buy a RRB Exchange-traded fund (ETF).
# After retirement, deplete the RRBs to provide the income floor, up to age 70 or 75
# Convert the remaining RRBs to an inflation-indexed annuity at age 70 or 75, if such things exist then, to eliminate longevity risk.post by member longinvest in Financial Wisdom Forum, November 18, 2016.
VetteseJonathan Chevreau, interview with Fred Vettese mentioned in A guide to having retirement income for life -- Decumulation tactics for the near-retired, MoneySense, February 15th, 2018 does not recommend inflation–indexed annuities because "they tend to be unpopular with both insurance companies and the public", by which he probably means that prices are not favorable for retirees due to lack of competition among different providers. MacDonald et al. wrote in 2013 that inflation-indexed annuities were "nearly non-existent in Canada". An alternative is annuities indexed to a pre-determined rate, e.g., 2%, but again these may be expensive.
==Using nominal bond ladders or ETFs==
For investors who think that inflation is under control and predictable, it is possible to use nominal bonds to construct the liability-matching portfolio. The basic idea is to build a ladder of nominal bonds extending to the final planning age (e.g., 95), with the combination of interest coupons and maturing bonds (principal) providing a stream of yearly income growing at the pace of anticipated inflation (e.g., 2% or more). Because this in part involves long bonds, the market value of such a portfolio would fluctuate significantly, but since the bonds are held to maturity, the income is safe.Westmacott G, Daley S (2015) The design and depletion of retirement portfolios. PWL Capital report, 27 p. Strip bonds could be used in the ladder to avoid dealing with coupons and to simplify calculations.
An alternative to building such a ladder of nominal bonds is to use GICs and nominal bond ETFs of various durations to simplify the portfolio. The proportions of the different ETFs and GICs would be varied as the investor ages, so that the duration of the portfolio matches the duration of the remaining liabilities.
Note that this strategy offers no protection against unanticipated inflation (because nominal bonds are used), and no protection against longevity risk beyond the final planning age. The final planning age could be extended to 100 or 105, but this will reduce the yearly income (or require more capital). A more dynamic, less expensive, method to provide partial longevity protection is described by Westmacott & Daley (2015).
==Pros and cons==
The following advantages and drawbacks can be listed for delaying government pensions and benefits, and the strategies that involve immediate life annuities (SPIAs):
Pros 	Cons
Annuities (or delaying government pensions and benefits) address longevity risk: at least your basic living expenses will come from protected income sources, which facilitates financial planning and budgeting 	Loss of bequest (legacy) and liquidity on the annuitized portion of the wealth; however, joint annuities are available and continue to provide income as long as one annuitant is alive
Removes investment risk (and the related worry) from the annuitized portion of the wealth; in the case of delaying government pensions and benefits, the funds for "bridging the gap" can go into cash GICSs, etc. also removing investment risk 	Most SPIAs provide constant nominal income, i.e. they have no inflation protection (but additional annuities can be purchased later to restore spending power, if needed)
Profit from mortality risk pooling (mortality credits) if you live longer than your life expectancy 	No ‘upside’ (including the equity risk premium) on the annuitized funds; not suitable for people with very short life expectancies or bequest motives
Having at least basic expenses covered with protected income sources might allow the retiree to take more investment risk in the remainder of the portfolio (in effect, the bonds have been replaced, at least in part, by annuities, a.k.a. "supercharged bonds")	For retirees who use an advisor, it might be difficult to find an advisor (other than a life insurance agent) readily willing to use annuities, since they decrease the asset base on which to charge the client fees
For strategies that avoid annuities (or use deferred annuities), where the investor is using fixed income products to build a self-managed liability-matching portfolio, advantages include:
* Eliminates downside risk for the portion of investable assets aimed at covering the income floor
* Knowing that the income floor will be covered by safe assets, and that aspirational goals will be covered by risky assets, has psychological benefits, as it makes an investor less prone to panicking in a big market downturn. Comment by member ghariton in Financial Wisdom Forum, November 13, 2016.
* Keeps the portfolio in the investor's hands for as long as possible, maintaining flexibility and liquidity
Whereas weaknesses include:
* DIY liability matching that completely avoids annuities is expensive because there is no mortality risk pooling
* RRBs and long nominal bonds are riskless from an income perspective, but have a high price volatility
==See also==
==References==
==External links==
* Financial Wisdom Forum, Risking Less and Prospering using Real Return Bonds?
*Bogleheads wiki: Matching strategy
Category:Retirement planning