Cash Flow Matching for Institutional Needs

Cash flow matching—also called dedication—constructs a bond portfolio where the coupons and principal payments exactly match known future liabilities (Koopmans and Becker, 1950s). A pension fund owing $10 million on January 15, 2030 buys bonds maturing that day for that amount. No interest rate risk. No reinvestment assumptions. The obligation gets met regardless of what happens to rates. The point is: when you know exactly what you'll owe and when, you can build a portfolio that simply delivers those cash flows—no hedging, no duration matching, no model risk.

Why Cash Flow Matching Exists (The Certainty Premium)

Most fixed income strategies manage risk through duration matching—ensuring asset and liability durations are equal so price changes offset. Duration matching works well in aggregate but fails on specifics:

Duration matching weakness #1: Reinvestment risk A 10-year duration can be achieved many ways. A single 10-year zero-coupon bond and a ladder of bonds with weighted-average 10-year duration both have duration of 10. But the ladder generates interim cash flows requiring reinvestment. If rates change, reinvestment occurs at different rates than assumed (Redington and Shiu, 1952).

Duration matching weakness #2: Convexity mismatch Duration measures first-order sensitivity. For large rate moves, convexity (second-order) matters. Portfolios with matching duration but different convexity profiles behave differently during rate shocks.

Duration matching weakness #3: Model assumptions Duration matching requires assumptions about yield curve behavior (parallel shifts) that don't hold in practice. The 2022 UK LDI crisis demonstrated this—gilt yields rose 100+ basis points in 4 days, violating parallel shift assumptions and causing massive losses for duration-matched strategies (Bank of England, 2022).

Cash flow matching eliminates these issues:

The causal chain: Identify liability schedule → Purchase bonds maturing at each liability date → Coupon + principal = liability amount → Hold to maturity → Liability met with certainty

No reinvestment. No duration drift. No model assumptions. Pure certainty.

The Basic Mechanics (Building a Dedicated Portfolio)

Your situation: You're a pension fund administrator with the following benefit payments due:

Cash flow matching approach:

Step 1: Start from the final liability (work backwards)

For 2030's $12 million liability, purchase a bond maturing in 2030 with face value + final coupon = $12 million.

If 2030 bonds yield 4.5% (semi-annual), a $11.48 million face value bond pays $12.0 million at maturity (face value + final coupon).

Step 2: Account for interim cash flows

That 2030 bond generates coupon payments before maturity. The 2029 coupon payment (~$258,000) reduces what you need to buy for 2029's liability.

2029 net liability: $11 million - $258,000 = $10.74 million

Purchase 2029 maturing bonds to deliver $10.74 million.

Step 3: Continue backwards through the schedule

Each year, subtract interim cash flows from longer-dated bonds, then fill the gap with bonds maturing that year.

The result: A portfolio of bonds with cash flows that precisely match liabilities. Total cost today = present value of liabilities discounted at portfolio yield.

Cash Flow Matching vs. Duration Matching (The Tradeoffs)

Neither approach dominates—each has strengths:

The practical tradeoff: Cash flow matching costs more (you sacrifice some yield for certainty) but eliminates model risk. Duration matching costs less but requires ongoing management and exposes you to assumption failures.

Why this matters: The 2022 UK pension crisis saw duration-matched LDI strategies lose 30-40% of value during the gilt crisis because leverage amplified model failures. Cash-flow-matched portfolios (rare in UK pensions) were unaffected—they simply held bonds to maturity.

Horizon Matching (The Hybrid Approach)

Pure cash flow matching for 30+ year liability streams is impractical—buying bonds maturing in 2055 for liabilities due in 2055 limits your options severely.

Horizon matching combines both approaches:

Near-term liabilities (0-10 years): Cash flow matched. These payments are imminent; certainty matters most.

Long-term liabilities (10+ years): Duration matched. These are far enough away that interim portfolio management adds value without excessive risk.

The causal chain: Segment liabilities by horizon → Dedicate near-term → Duration-match long-term → Review annually → Extend dedication as liabilities approach

Example implementation:

• Liabilities 2024-2034: Fully cash flow matched (dedicated bond portfolio)
• Liabilities 2034-2054: Duration matched to liability duration
• Each year, bonds maturing cover that year's payments; portfolio is extended to maintain 10-year dedication horizon

Why this works: Near-term certainty (where timing precision matters most) combined with long-term flexibility (where small mismatches compound less).

Institutional Applications (Who Uses This)

Defined benefit pension funds: The classic use case. Known benefit payment streams (based on actuarial projections) match well to cash flow dedication. Pension funds with frozen benefits (no new accruals) are ideal candidates—liabilities are fixed and predictable.

Life insurance companies: Insurance companies selling annuities know exactly what they'll pay and when. A $1 million life annuity paying $60,000 annually for 20 years is a perfect cash flow matching candidate.

Bond defeasance: Corporations wanting to remove debt from their balance sheet can purchase a Treasury portfolio matching the bond's remaining cash flows. The liability is legally defeased, improving financial ratios.

Structured settlements: Legal settlements paid over time (personal injury, divorce) use cash flow matched portfolios held by insurance companies.

GIC portfolios: Guaranteed Investment Contracts issued by insurers match investor contributions to bond cash flows, locking in spread.

The Cost of Certainty (Quantifying the Yield Sacrifice)

Cash flow matching isn't free. The constraints—specific maturities, specific amounts—reduce portfolio yield versus an optimized duration-matched approach.

Typical yield sacrifice: 15-40 basis points annually

Sources of the yield sacrifice:

Limited bond selection: You need bonds maturing on specific dates, not whatever's cheapest in that duration bucket.

Odd lot purchases: Matching $847,000 in liability requires buying that amount, often at worse prices than round lots.

No credit optimization: A duration-matched portfolio can overweight cheaper (higher-yield) sectors. Dedication constrains this.

Lower turnover opportunities: Duration-matched portfolios can trade to capture mispricings. Dedicated portfolios hold to maturity.

When the sacrifice is worth it:

The 15-40 bps annual cost buys elimination of model risk. For a 20-year liability stream, model risk during a crisis (like 2022) can cause 10-30% value destruction in a single event. Cash flow matching trades small annual cost for protection against catastrophic failure.

The calculation:

• 30 bps × 20 years = 600 bps cumulative cost of dedication
• Model failure risk (assume 15% probability of 20% loss): 300 bps expected loss
• Apparent cost > expected benefit

But: The 2022 UK LDI crisis showed that model failures are correlated with funding crises—they happen precisely when you can't afford them. The certainty premium has insurance value beyond expected loss calculations.

Implementation Checklist

Essential (get these right first)

These four items ensure dedication works as intended:

• Verify liability schedule accuracy (actuarial projections, legal obligations)
• Match maturities within 30 days of liability dates (avoid cash timing gaps)
• Use highest-quality credits only (AA or better to avoid default risk)
• Account for bond call provisions (callable bonds introduce reinvestment risk)

High-impact (for robust implementation)

For institutions building multi-decade dedication programs:

• Build reinvestment buffer (1-2% excess cash flow for cushion)
• Document roll-forward procedures (annual extension of dedication horizon)
• Establish credit migration triggers (sell rules if credits deteriorate)

Advanced (for complex liability streams)

If liabilities vary by scenario (e.g., pension COLAs, insurance contingencies):

• Model liability scenarios (base, stressed, favorable)
• Dedicate to worst-case scenario (or probability-weighted)
• Identify contingent liabilities requiring different treatment

When Cash Flow Matching Works (And When It Doesn't)

Ideal candidates:

• Frozen pension plans: Fixed benefit payments, no new accruals, high certainty
• Annuity books: Contractually defined payment streams
• Structured settlements: Legal obligations with specific payment dates
• Bond defeasance: Precise cash flow requirements, regulatory drivers

Poor candidates:

• Active pension plans: Benefit accruals change liabilities; dedication wastes resources
• Uncertain liabilities: Healthcare costs, variable benefits—can't dedicate to unknowns
• Long-dated liabilities only: 40-year dedication is impractical; use horizon matching
• Taxable portfolios: Tax treatment of dedication differs; may be suboptimal

The durable lesson: Cash flow matching trades flexibility for certainty. Use it when certainty has high value (near-term, mission-critical payments) and avoid it when flexibility matters more (long-term, uncertain obligations).

Related Concepts

Liability-driven investing: The broader framework for matching assets to liabilities. See: Liability-Driven Investing Basics.

Duration matching: The alternative approach for liability management. See: Barbell vs. Bullet vs. Ladder Approaches.

Immunization: Strategies combining duration and convexity matching. See: CFA Institute LDI curriculum materials.

Portable alpha: Separating beta from alpha in institutional portfolios. See: Portable Alpha Concepts in Fixed Income.

Next Step (put this into practice)

Assess whether cash flow matching fits your liability profile:

How to do it:

1. List your next 10 years of known liabilities (pension payments, debt service, contractual obligations)
2. Categorize each by certainty: Fixed (contractual), Highly probable (actuarial), Uncertain (variable/contingent)
3. Calculate total "fixed" liabilities as percentage of total
4. If fixed > 60%, cash flow matching is likely appropriate for that portion

Interpretation:

• Fixed liabilities > 80%: Strong candidate for full cash flow matching
• Fixed liabilities 60-80%: Consider horizon matching (dedicate near-term, duration-match long-term)
• Fixed liabilities < 60%: Duration matching likely more appropriate; too much uncertainty for dedication

Action: For your highest-certainty liabilities, request bond portfolio quotes from 2-3 fixed income managers specifically for cash flow matching. Compare cost (yield sacrifice) to your current duration-matched approach.

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References

Bank of England. "Financial Stability Report - LDI and Gilt Market Stress." November 2022.

CFA Institute. "Liability-Driven and Index-Based Strategies." CFA Program Curriculum, Level III, 2024.

Koopmans, T.C. "Asset-Liability Management Origins." Penn Mutual Life Insurance Company research, 1950s. Referenced in CFA Institute materials.

Redington, F.M. and Shiu, E.S.W. "Review of the Principles of Life-Office Valuations." Journal of the Institute of Actuaries, 1952.