What is combination matching and why do pension funds prefer it?

Question

AcadiFi · Accepted Answer

Combination matching (also called horizon matching) is a hybrid strategy: cash-flow match the near-term liabilities (typically 0-5 years) and duration-match (immunize) the longer-term liabilities. It captures the strengths of both. Rationale: 1. NEAR-TERM LIABILITIES are most important to match exactly because any shortfall hits immediately. Cash-flow matching guarantees these payments. 2. LONG-TERM LIABILITIES benefit from the higher yield and lower cost of duration matching, while offering time to rebalance if rates move. 3. Combination minimizes reinvestment risk on near cash flows (cash-flow matched) while preserving flexibility on distant cash flows (duration matched). Example: Summithaven Pension has: - Years 1-5: $3M per year ($15M total). - Years 6-25: PV ~$65M. Combination approach: - DEDICATED BUCKET ($13.5M PV of zero-coupon Treasuries): One zero per year for years 1-5. - IMMUNIZED BUCKET ($65M PV): Duration-matched to the Macaulay duration of the year 6-25 cash flows (~12 years). Build with a mix of medium and long corporates. Total: $78.5M invested. Benefits over pure immunization: - Year 1-5 payments are GUARANTEED (zero-coupon Treasuries mature exactly as needed). - No rebalancing risk on near liabilities. - Year 6+ benefits from higher yields on corporate bonds. Benefits over pure cash-flow matching: - Lower cost (~$3-5M cheaper than matching all 25 years). - Easier to find bonds for distant years. - Duration matching allows optimization. ```mermaid flowchart TD A[Liabilities] --> B[Split] B --> C[Yr 1-5
Cash-flow
Match] B --> D[Yr 6-25
Immunize
D=12] C --> E[Guaranteed] D --> F[Rebalance] ``` Most large DB pension plans use combination matching in practice. CFA Level III often asks candidates to compute the PV of each bucket and discuss tradeoffs.

What is combination matching and why do pension funds prefer it?

Master Level III with our CFA Course

Related Questions

Practice Questions