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.

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.