What it means
Many organisations know in advance roughly how much they will need to pay and when. A pension fund must pay retirees every month, an insurer must pay claims, and a company may have a bond to repay in ten years.
Liability matching starts by mapping those future payments, and then builds a portfolio designed to produce cash at the same times. There are several techniques.
Cash flow matching buys bonds whose coupons and maturities fall on the same dates as the liabilities, so every payment is covered directly. Duration matching, also called immunisation, aims to make the average timing and interest rate sensitivity of the assets equal to those of the liabilities, so that changes in rates affect both sides similarly.
The reason this matters is interest rate risk. When rates fall, the present value of a long-term liability rises, because the same future payment is discounted at a lower rate.
If the assets do not rise by the same amount, the fund develops a deficit even though nothing else has gone wrong. Liability matching reduces this risk but also gives up some potential return.
Safe bonds that match the liabilities typically earn less than shares, so the organisation must balance security against the cost of contributions. Many pension schemes therefore match part of their liabilities and invest the rest for growth.
The approach is often described as liability-driven investing. It is not a guarantee, because the liabilities themselves may change, for example if people live longer than expected or inflation is higher than forecast.
Regular reviews and adjustments are part of the discipline.
In practice
Real-world examples.
Example
A pension fund expects to pay about $8,000,000 in pensions each year over the next ten years. It buys bonds that mature in each of those years to cover the payments. The fund's trustees can then focus on investing the remaining assets for growth.
Example
A life insurer sells annuities that pay fixed amounts for decades. Its treasury team builds a portfolio of long-term bonds with similar duration to the annuity payments. Changes in interest rates affect the value of the assets and the liabilities by similar amounts.
Example
A manufacturing company has a $20,000,000 bond maturing in seven years. The finance team builds a sinking fund invested in safe securities designed to reach $20,000,000 by the repayment date. The matching removes the worry of refinancing at a bad moment.
Formula
Calculation
Cost today of matching a single future liability = Liability / (1 + Yield) ^ Years
Worked example: a company must pay $1,000,000 in 5 years. It can buy a zero-coupon bond (a bond that pays nothing until maturity) with a yield of 4% that pays $1,000,000 at that date.
(1.04) ^ 5 = 1.2167 (rounded to four decimal places).
Cost today = $1,000,000 / 1.2167 = about $821,927.
By buying the bond for about $821,927, the company is certain to have $1,000,000 in 5 years, whatever happens to interest rates in between. If it instead held $821,927 in a savings account with a variable rate, the final amount could be higher or lower than $1,000,000, leaving a gap risk.Case study
Seen in the real world.
Tideline Pension Scheme is a fictional scheme with liabilities of $200,000,000 and assets of $200,000,000, so it was fully funded. Its assets were mainly shares, while its liabilities behaved like long-term bonds.
When interest rates fell, the present value of the liabilities rose by 12% to $224,000,000, while the assets rose only 3% to $206,000,000. The funding gap grew to $18,000,000, and the sponsoring company had to increase its contributions.
The trustees then moved 60% of the portfolio into bonds matched to the pension payments. The next time rates moved, the gap barely changed. This is an illustrative story, but it shows the problem that liability matching is designed to solve.
Watch out
Common mistakes.
- Believing that matching removes all risk. Longevity, inflation and credit risk can still change the position, and the liabilities may need to be re-estimated.
- Matching assets to the wrong liability measure. If the liabilities are linked to inflation, nominal bonds will not hedge them properly.
- Ignoring the return cost. Safe, matched assets usually earn less than growth assets, so contributions may need to be higher.
Questions
People also ask.
What is the difference between cash flow matching and duration matching?
Cash flow matching lines up each payment date with an asset that pays on that date. Duration matching only aligns the overall sensitivity to interest rates and is easier to run.
Who uses liability matching?
Pension funds, insurers, banks and companies with known future payments such as debt repayments. It is also used by individuals who buy annuities.
What is liability-driven investing?
It is a broader name for strategies that choose investments according to the liabilities they must fund. Liability matching is the core idea behind it.
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