Liability matching

Liability matching strategies allow an investor planning for retirement or other goals to meet specific financial targets with near certainty. 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.

Introduction
Risk is managed in life-cycle finance using hedging, insuring, and diversifying. 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. 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.

Liability matching in retirement planning
In the context of retirement planning, the 'liability' that needs matching is a retirement income floor (see Dual Budget model), indexed for inflation.

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 this income floor, but for many Canadians that will not be enough. The missing portion to reach the income floor can be obtained by delaying OAS and CPP/QPP to increase the amounts; with a liability matching portfolio; with annuities; or a combination of methods. This is what Milevsky and Macqueen call "pensionizing your nest egg".

Several 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 OAS and CPP/QPP
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. For further discussion see:
 * OAS: when to Apply
 * Delaying CPP
 * Delaying QPP

Many peoples’ acceptable income floor will be higher than OAS + CPP/QPP, especially for single investors (as opposed to couples). But OAS and CPP/QPP can be viewed as inflation-indexed annuities, which you can increase significantly by delaying them. Taking delaying only 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. Assume 0% real return: you need five times the yearly OAS amount at age 70, currently totaling $47.6k. 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 (2, 3, 4, 5 years), or perhaps in a short term bond ETF. 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.

If this isn't enough, other strategies can be added to further increase the safe income floor.

Using real return bonds and indexed annuities
Because the income stream needs to keep pace with inflation, ideal liability-matching products are inflation-indexed life annuities and Real Return Bonds (RRBs). The strategy could be as follows:
 * 1) 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).
 * 2) After retirement, deplete the RRBs to provide the income floor, up to age 70 or 75
 * 3) Convert the remaining RRBs to an inflation-indexed annuity at age 70 or 75, if such things exist then, to eliminate longevity risk.

Vettese 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 B-J 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%). 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. 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).

Using immediate fixed annuities
Vettese (2018) 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.

Immediate fixed annuities provide income for life, so they take care of longevity risk. However their purchase is not reversible, partly explaining why they are not more popular. Handing all your capital over to an insurance company does not sound appealing. But 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”.

Using deferred annuities and bonds
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. One purpose of this product is longevity insurance. For example, you could set up a ladder of bonds (nominal or real return bonds) to cover retirement income needs for the first 20 years, and use a deferred annuity to provide income afterwards. 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.

Advanced-life deferred annuities (ALDAs) are problematic in Canada because of the tax treatment, so for now, "Canadians do not have this option". However, the 2019 federal budget proposed to amend the tax rules to allow them.

Strengths

 * Liability matching 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.

Weaknesses

 * Liability matching with RRBs is very expensive. It assumes that the non-RRB portion of the portfolio might actually go to zero, which seems extremely unlikely.
 * RRBs and long nominal bonds are riskless from an income perspective, but have a high price volatility
 * If annuities are used, the decision is irrevocable and liquidity is lost
 * Annuities are not suitable for people with very short life expectancies or bequest motives