Personal Finance: Matching Assets and Liabilities

Personal Finance: Matching Assets and Liabilities
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Personal Finance: Matching Assets and Liabilities

An email from a reader:

I saw some of your articles on Seeking Alpha, then read through a bit of Aleph Blog.  Thanks for writing the articles, they are quite interesting.  I have seen the advice “Match Assets and Liabilities” more times than I care to count.  And your insurance example is a very clear one.  However, I have never seen a clearly worked example for an individual.  When I look at it for my own case I never quite see a clear optimality from matching assets with liabilities.  Perhaps part of the difficulty is that most individual liabilities (or at least for me) are flexible in some way (vacation – luxury or basic?).  Another issue is that my major “asset” is my salary – which produces vastly more income than my assets.  So I’d love to see you (or anyone) work out a clear example of how matching works for an individual, particularly one with more salary income than investment income.

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If you care for some numbers, here is my rough case:

0) I have a significant buffer.  Green light here.

In addition to the buffer, enough cash to prefund all of the following:

1) 5,000 liability in 2 months

2) 20-30,000 liability in 6-12 months (I have some, but not total, flexibility in timing and amount)

3) 40-60,000 liability in 2-4 years (again flexibility, and hope that investment return could help increase the number)

After that are two larger expenses which I don’t have sufficient cash for.  The amounts would be significantly modified based on investment returns:

4) 100-200,000 purchase to upgrade house  in 5 to 10 years

5) In 30 years retire based solely on savings.

Let me start by mentioning two old articles:

Personal Finance, Part 11 — Your Personal Required Investment Earnings Rate [PRIER]

Personal Finance, Part 12 — Longevity Risk

Both concepts play a large role in what I will write here, but I am not going to repeat them here.  I’ll try to keep this simple.

Intuitively, people know that they need to match assets and liabilities, but they sometimes forget that when greed or fear emerge.  If I am planning on buying a house next year, and I have just enough for the down payment and closing costs, why do I not invest the money in stocks?  Because I might not be able to follow through on my goal if the market drops.

If I am planning on retiring in 30 years, but I am risk-averse, why shouldn’t I invest all my money in a short-term bond fund?  Because higher long-run average returns result from bearing moderate risk.  On average, maximum returns result from bearing moderate risk over long periods of time.

So, how does this calculation work?  You create two columns of numbers.  The first column is what I need to fund.  Now when I say that I am not talking about regular living expenses. I am talking about the big ticket items that are required, and that you know about now.  Plot out those cash flows, year-by year.   For the really long cash flows, like retirement, you might want to add in an adjustment for inflation.

The second column is how much you will save each year after regular living expenses, including the excess assets that you have now.  The difference between those two columns is your net cash flow profile, and by using the IRR or XIRR function in Excel, you can figure out your PRIER.

Don’t expect to earn much more than what long Baa/BBB bonds yield now (presently 4.7%).  If the PRIER is so high that you know that you can’t earn that, then it is time to make hard choices:

  • Save more
  • Reduce goals
  • Work longer
  • Etc.

Now, as to the investment of funds to achieve those goals, it’s not that complex.  Inside five years, buy short/intermediate term bonds. 5-10 years half intermediate bonds, half risk assets, like stocks. 10-20 years should be 75% risk assets, 25% long bonds.  Beyond 20 years, 100% risk assets, or, extremely long bonds if attractive.

When I say this, I do not mean to ignore market conditions.  There are times when risk premiums are low, like now, 2000, 2007, and it does not look like risk will be rewarded on average over the next ten years — that is a time to preserve capital.  Then there are times when the market has washed out — 2002, 2009, those are times to take more risk.  Stocks are harder to measure, so if you need better guidance, look at the yields on junk bonds.

Asset allocation is a compromise between matching assets and liabilities, and examining relative advantage in the asset markets.  Sometimes stocks are better than bonds, or vice-versa.  Gold works well during times of financial repression.

In Closing

There are a number of key variables we don’t know here:

  • Future inflation
  • Likely savings
  • Asset returns in nominal or real terms

A good plan will attempt to leave some slack in case asset returns are lower than expected.  I would not assume that I could earn more than 5%/year over the long run, or maybe 2.5% after inflation.

Given what I know, this is the best answer I can give.  With more data, I could sharpen it.  But the really hard part is estimating expenses when retirement is a long way off.

By David Merkel, CFA of alephblog

Updated on

David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.
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