Everyone loves talking about portfolio income and cash flow matching, how dividends and bond interest will cover your expenses forever—until, of course, they don’t. The real solution isn’t to live off the income your portfolio throws off. That’s a mirage. The actual way to cover your future liabilities is to match assets directly to them. Sounds obvious, right? Yet, somehow, people still cling to the idea that they can live off the yield without touching the precious principal. Spoiler alert: you’re going to need to spend that principal. And that’s not a bad thing.
Here’s the difference with asset-liability matching: it’s not about squeezing every last drop of interest or dividends from your portfolio. It’s about making sure that when your expenses comes due—be it retirement income, tuition, or long-term care—you have the funds to meet it, no matter what. And to do that, you don’t need just income; you need to use the whole asset—principal and interest combined. The game isn’t to never spend your portfolio; it’s to have the right amount at the right time.
Spend the Principal? It’s Not a Sin, It’s the Point
Picture this: you’ve got $50,000 of expenses 20 years from now. Instead of hoping interest rates stay high or dividends keep flowing, you buy a 20-year inflation-protected bond (TIPS). You lock in today’s real rate, say 1.5%, plus the inflation adjustment and today it costs you $37,123. In 20 years, it will mature at $50,000 plus inflation. Now, you’re not just sitting around hoping for decent income. You’ve matched your asset directly to your liability. In 20 years, when the bill comes due, you’re ready to pay it with both principal and interest—guaranteed.
That’s the core idea. You’re not living off the interest and protecting the principal as if it’s some sacred cow. You’re using the asset itself, spending both interest and principal, to meet your liability.
And guess what? While you’re using part of your portfolio to cover specific liabilities, the rest of your money—your risk bucket—is still growing. You’re not going to run out of money just because you’re spending down some of your principal. Far from it. The rest of your assets are still in the market, compounding and working for you, building up future wealth. So, no, you’re not depleting your portfolio. You’re simply being smart with how you match your assets to your future expenses.
Why Constraining Duration Is the Real Risk
Here’s where things get tricky. A lot of people think they can avoid volatility by holding short-term bonds or cash-flowing stocks with juicy dividends. Seems safe, right? Wrong. You’ve just walked straight into a trap.
Let’s say you have a 20-year liability, but instead of locking in a 20-year bond, you buy a 5-year bond because it seems “safer” (less price movement, more stability). What happens when that bond matures in 5 years? You’re forced to reinvest it, and if interest rates have dropped, you’re stuck with whatever the market gives you. Remember 2007? Rates were decent, but within a year or two, we were in a zero-rate world. Anyone rolling over their bonds in 2010 was getting next to nothing. If you were counting on that yield to cover future expenses, you were toast.
By constraining duration, you’re playing Russian roulette with your financial future. You might avoid some short-term volatility, sure, but you’re exposing yourself to reinvestment risk. That’s a fancy way of saying, “What if interest rates suck when my bond matures?” If you need to keep rolling over short-term bonds or hoping for dividends, you’re gambling with future income. If rates or dividends collapse, your plan collapses with it.
Contrast that with a long-term bond. Sure, its price might fluctuate as interest rates move, but here’s the kicker: if you’re holding the bond to maturity, none of that volatility matters. You’ve already locked in the return that will meet your future obligation. Even if interest rates rise and the price of your bond drops, you don’t care because the principal and interest are still going to cover your liability when the time comes.
You’re Chasing the Wrong Risk
Everyone freaks out about price volatility. “Oh no, my bond fell 10%!” they scream. But here’s the thing—volatility isn’t the real risk. The real risk is running out of money when you need it. If you’re spending all your time trying to minimize short-term price movements, you’re missing the forest for the trees. Asset-liability matching is about making sure you have the funds to cover future expenses, not about smoothing out every blip in your portfolio’s value.
If you’ve matched your asset to your liability, that 10% price drop doesn’t matter. What matters is that when you need the cash in 20 years, it’ll be there. Volatility? It’s just noise. The risk of not having enough assets to cover your liabilities? That’s the signal. That’s what you should focus on.
Stop Playing Defense, Start Planning for the Future
So let’s be clear: constraining duration or chasing dividends feels like a defensive move, but it’s actually a dangerous bet. You’re just hoping that things stay stable enough for you to get by, but hope isn’t a strategy. Asset-liability matching, on the other hand, is about locking in what you know will work. It’s the difference between controlling your financial future and leaving it to chance.
In short, stop worrying about volatility and focus on matching your assets to your liabilities. It’s not about preserving your portfolio like some ancient treasure—it’s about making sure you can pay for what you need, when you need it. If you’re doing that, the rest of your portfolio can continue to grow and take on risk, setting you up for a solid future while ensuring your known obligations are met.
This isn’t just smart—it’s essential.
John Grubbs, CAIA®, AAMS®
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