“Asset-Liability Matching” Aligns Your Money to Your Future

I see some people thinking about their portfolios incorrectly, and a concept called “asset-liability matching” can help.

Let’s imagine a portfolio…50% stocks, half US and half international. Plus 50% bonds, half short duration (~2 years) and half longer duration (~8 years). To make life simple, I’m going to use some ETFs to “build” this portfolio:

• ITOT: Total US Stock Market
• IXUS: Total International Stock Market
• IEF: 7-10 Year US Treasury
• SHY: 1-3 Year US Treasury

When I originally penned this post, these four ETFs’ performances over the past 2 months had been, respectively:

• (-14.6%)
• (-1.7%)
• +1.0%
• +0.8%

Combining those numbers, our portfolio of equal weights in all four ETFs is down (-2.8%) over the past eight weeks. That doesn’t feel good.

But I contend that this simple summary of performance is NOT the right way to think about our portfolio. That’s where asset-liability matching can help out.

Tale of Two Assets

While we could consider the entire portfolio to be down (-2.8%), that’s a poor mental model.

Instead, I want to divide our portfolio in two. Our stock allocation is the “long-term growth” half of our portfolio. The bond allocation is the “near-term spending” half of our portfolio. Depending on the individual investor’s preferences, that “line” between near-term and long-term is probably drawn 8 years, 10 years, or even up to 15 years in the future.

Let’s now re-examine this year’s performance in two halves.

The long-term growth half is catching some flak! It’s down (-8.2%) over the past two months. Not ideal. Thankfully, though, because we’ve “drawn our line” 10+ years in the future, we don’t care too much about two months of poor performance. In this half of the portfolio, we measure in decades and aren’t bothered by short-term performance.

What about the “short-term spending” bond side of the portfolio? It’s actually up +0.9% over the past two months. This is the half of the portfolio that matters most to this week, this month, this year, etc.

In other words…why fret?! The half of the portfolio that matters most right now is up. And the half that’s down? It has a decade (or more) to recover.

This is why I start with financial planning before building a portfolio. A financial plan assigns objective numbers to the goals and timelines in our lives. Some are near-term goals, others long-term. Each goal has its own “asset-liability match.” Asset-liability matching (ALM) ensures the money you will need (your future liabilities) is supported by the money you already have (your assets), while lining up the risk of those assets based on the unique timing of that specific need.

In fact, we can use ALM to build an entire portfolio from the ground up.

Asset-Liability Matching Example in Our Portfolio

Let’s use asset-liability to build a portfolio, and we’ll do the right thing by start with a basic financial plan. In other words, we haven’t yet settled on our “25% in 4 ETFs” portfolio just yet.

Fast forward: we run the details of our plan and find that we plan to spend $50,000 per year. I’m using round numbers to keep the math easy. I’m also going to eliminate inflation from all the math here. Yes – you can do that. Let’s also assume we have $1.2M in investable assets.

So that means:

• Our spending never changes. It’s always $50,000 per year.
• Our bonds have 0% return. We’re going to assume they have no real return above inflation.
• Our stocks have a 6% annualized return. However, based on historical data of stock returns and volatility, it might take 10, 15, or more years to fully average out to that expected return

So we know our liabilities. For Years 1 – Infinity, we need $50,000 per year. Now we must match those liabilities with assets.

The key – and beautiful logic – is that short-term liabilities must be matched by a “short-term asset.” That is, an asset with a high degree of certainty over short time periods, aka low risk. Long-term liabilities can afford risk and volatility because they have time on their side. We can use a higher-risk asset to match long-term liabilities and assume a higher rate of investment return along the way. We are matching liabilities to appropriate assets.

Let’s start with Year 1. Our financial plan has a $50,000 liability in Year 1. How does that liability get funded? I need to match it to an asset. Since this next year is such a short timeline, I cannot take risks. Thus, I will match this liability to $50,000 in bonds (specifically, the short-duration ETF SHY). Since I’m assuming 0% growth from SHY, I must allocate a full $50,000 to SHY.

I rinse and repeat for many years to come. If I wanted to be detailed, I could build a bond ladder or a set of specific bond funds for every duration I encounter e.g. Year 2 is covered by 2-year bonds, Year 3 is covered by 3-year bonds, etc.

For the sake of simplicity, let’s keep to our 2 ETFs from before:

• We’ll use SHY, the short-term bond ETF, to cover the next 5 years of spending at $50,000 per year. That leads us to a $250,000 allocation to SHY.
• We’ll use IEF, the longer-duration bond ETF, to cover spending liabilities from Year 6 through Year 12. That leads us to a $350,000 allocation to IEF.
• Since this entire example today emphasizes simplicity above fine-tuned detail, I’m content with simplifying this bond allocation to $300K each of SHY and IEF.

Now – what to do about Year 13?

Remember that “line” we drew earlier that separated our “short-term spending” from our “long-term growth?” Humor me: we will draw the line conveniently after Year 12. In other words, we’re going to say:

“I am comfortable assuming that after 12 years, my stock portfolio will have gone through ups and downs, and its average return will resemble the long-term average of 6% per year, inflation-adjusted. Starting in Year 13, I am comfortable taking that future liability, matching it to my stock assets, and then assuming a rate of return on those stock assets between now and then.”

This is where the asset-liability matching model gets fun.

Because if I require $50,000 in Year 13, and I’m assuming a 6% annualized return from my stock portfolio, then I must set aside “only” $25,000 of my assets today. Because 6% compounded for 12 years = 2x, and the $50K divided by 2 yields $25K. Whereas before, assuming a 0% return from bonds, I needed to match a full $50,000 in bond assets for a $50,000 liability.

Year 14 is even better. With one more year of compounding at 6%, I only need to set aside $23,500 today.

Year 15 requires $22,100 today.

Eventually, with even time and enough compounding, today’s requirement converges on zero.

• Year 30 requires $9200 of assets today.
• Year 40 = $5100
• Year 50 = $2900
• Year 100 = $156
• Year 200 = $0.46

Yes, if you take 46 pennies and compound them at 6% for 200 years, you will have the $50,000 in spending money you need for that year. Our mortal financial plans probably don’t need to consider Year 50 or Year 100 or 200. But, this asset-liability thought process is how many university endowments conceptualize their investment plans. Essentially, they have some assets on their balance sheets with infinite timelines.

Back to today’s example: if I earmark stocks to cover my liabilities from Year 13 to Year 50, I’ll need ~$390,000. If you’re keeping track at home, we’ve allocated $600,000 to bonds, $390,000 to stocks, and $210,000 left over.

Perhaps I also invest that remaining $210,000 in stocks, assigning them an “infinite” timeline**, and leave those assets to my heirs or charity. Many people choose to do this. If we did so, that would bring our stock allocation to $600,000 total. Dividing that evenly between domestic and international stocks (ITOT and IXUS, respectively), we’ve constructed our beginning portfolio using asset-liability matching.

**If you’ve ever considered opening your own “investing sandbox” or “play money” or “I want to experiment!,” I recommend you use this kind of “leftover” money with an infinite timeline.

The $600,000 in bonds is still covering Years 1 through 12. That should make us feel decent.

And yes, perhaps the $600,000 in stocks did drop (-8.2%), down to $551,000. In my particular example, though, where we had $210,000 of “infinite money,” our financial plan is literally not affected at all! Despite being down ~$50K, we are still in a position where every liability we could ever have is matched with an asset. That should feel great.

Granted, it’s my hypothetical. Perhaps your financial plan looks different. But that brings up a worthwhile question: what about rebalancing?

How Does Rebalancing Work With Asset-Liability Matching?

Rebalancing is a key part of portfolio management. We expect our portfolio will drift from its target allocation, and rebalancing brings it back in line.

Strictly speaking, asset-liability matching doesn’t require rebalancing to a specific allocation. Instead, it requires rebalancing based on the normal, expected shifts of our liabilities and our assets.

Let’s continue with our example from above. We had $50,000 set aside in the short-term bond ETF SHY in order to cover our Year 1 liability. Once Year 1 has passed, I’d expect a few things to be true:

• We have $50,000 less in SHY, due to our planned withdrawal
• Our remaining bond assets (in SHY and IEF) might show a small change from the past year.
• Our stock assets (in ITOT and IXUS) might show a large change from the past year.

But, now starting Year 2, we go back to the drawing board. Asking questions like:

• First…have our liabilities actually changed? We anticipated needing $50,000 in Year 1, so I’m curious how true that was. Let’s assume we were right on.
• Do we have 6 years of spending, or $300,000, in SHY? Probably not, since we just spent $50,000 in Year 1.
• Do we have the subsequent 6 years of spending in IEF? Probably close. We don’t expect much inflation-adjusted return here.
• Is our stock allocation still close to 50% ITOT and 50% IXUS? Total wild card. Who knows how much ITOT and IXUS might change in a single year..

In our stocks performed well in Year 1, we could very possibly shift from our 50/50 portfolio starting point to 55/45. And if stocks performed poorly in Year 1, perhaps we start Year 2 at 45/55. For those keeping track at home, you might realize: based on historical stock and bond performance, an asset-liability matched portfolio will almost certainly change allocation over time, with an ever-rising percentage allocated to stocks.

That’s ok, in this particular example, as long as we still have 12 years’ of bonds.

In asset-liability matching, the point is not to rebalance to precisely where we started (i.e. 50/50). Instead, the point is to rebalance based on current best understanding of our future liabilities.

Sometimes, it’s ok NOT to rebalance.

Still, I think it’s a good exercise view our portfolios through the lens of asset-liability matching. We don’t need to fully adopt it if we’re not comfortable. But it helps align our money with our future…and probably helps us sleep better at night, too!

Thank you for reading!

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-Jesse

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