How do I design a cash flow matched bond portfolio for a pension liability stream?

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AcadiFi · Accepted Answer

Cash flow matching (dedication) builds a bond portfolio where coupon and principal payments exactly meet each future liability. For a 20-year stream of pension payments, start with the latest liability and work backward. Year 20 liability $18M: buy zero-coupon Treasury or a STRIPS package maturing year 20, face $18M. Year 19 $19M: buy year-19 STRIPS face ~$19M, minus any coupons from longer bonds that fall in year 19. Year 18 and earlier: continue backward, crediting incoming coupons from later-dated bonds toward earlier liability needs. Result: a ladder of bonds where each year's total cash inflow meets that year's benefit payment. Tradeoffs vs immunization. Cash flow matching eliminates reinvestment risk and interest rate risk entirely (if bonds are default-risk-free). Immunization matches duration and convexity but can suffer from parallel vs non-parallel rate shifts. CFM is more conservative but typically more expensive (2-6% higher PV required) because you must buy exact-maturity bonds rather than optimize across the yield curve. Practical constraints. Use Treasuries, agencies, and highest-grade corporates. Avoid callable bonds (uncertain cash flow). Allow small overfunding (1-3%) for safety and reinvest small gaps at short rates. Consider TIPS for inflation-linked liabilities. Monitor credit risk; downgrades can force rebalancing. Transaction costs for building a 20-year ladder: 10-30 bps total, plus bid-ask spread on less liquid maturities. Revisit annually to roll and address mortality or plan demographic changes. CFM is ideal for closed plans with certain cash flows; immunization is better for open plans where duration targeting is flexible.

How do I design a cash flow matched bond portfolio for a pension liability stream?

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