Cashflow Matching Strategies

Introduction

In the recent higher interest rate environment, improved pension funding levels, and persistent volatility, we believe plan sponsors and consultants are turning to cashflow matching that seeks to maintain liquidity, hedge plan funded status, and directly align assets with future benefit payments. Cashflow matching, one of the original forms of liability hedging, involves structuring bond portfolios whose coupon and principal payments correspond to plan obligations. The approach may help support meeting payments, reducing funded status volatility, and potentially generating outperformance relative to liability growth rates. Implementation vehicles can span Treasuries, corporate bonds, securitized assets, private placements, and direct loans.

Current State of the Market and Pension Plans

With the increase in interest rates from 2022 to 2025, yields may present conditions more supportive of cash-flow matching than may have been seen four years ago . Additionally, for pension plans in an overfunded position, market volatility may present a context in which increasing hedge exposure could help manage funded-status variability and may support future benefit payments. Cashflow matching may be a consideration for a variety of pension plan types with different implementations and objectives. Some of the types of plans and their unique considerations are introduced below.

The average corporate pension plan is currently in an overfunded state after years of underfunding¹. With the lessons learned from the prior two decades of funded status volatility, we believe plan sponsors have been eager to maintain their plans’ higher funded status. We see plans that have implemented liability driven investment approaches using long duration fixed income assets. Some plans have also begun to use cashflow matching as a tool that seeks to more directly match benefit payments up to 30 years in the future.

Public pension plans, or mature corporate plans that have closed to new participants or have frozen future benefit accruals, may have a negative cashflow profile, meaning the plan could be paying out more assets in benefit payments than it is collecting in contributions. This consistent need for cash outlay creates an acute awareness of portfolio liquidity and a heightened sensitivity to market downturns, where the possibility of the forced selling of distressed assets may be required to pay monthly benefit payments. Cash flow matching for near-term benefit payments is intended to provide liquidity to meet those obligations, which may help reduce reliance on the sale of other portfolio assets during periods of market stress.

Some severely underfunded Taft Hartley plans received a cash injection from in the special financial assistance (SFA) program under the American Rescue Plan Act of 2021. The goal of the SFA funds is to ensure that the participants of these multiemployer pension plans receive their earned pensions for as many years as possible. Therefore, one of the stipulations for plans to receive the additional funds is that they are required to invest at least two-thirds of the funds in investment grade fixed income assets.² Cashflow matching has become a popular strategy within these plans as they seek to balance the dual mandate of paying benefit payments and attempting to outearn the plan’s liability in an effort to extend the solvency of the plan.

Considerations When Building a Cashflow Matching Strategy

When building a cashflow matching portfolio, the goal is to match future expected bond coupon and principal payments to expected future participant benefit payments. However, there are many factors to consider when building a bond portfolio, specifically the type of bonds to be included in the portfolio. The range of bonds can include Treasuries, corporate credit, securitized assets and private debt.

A cashflow matching portfolio tends to be a buy-and-hold bond portfolio that will roll down over time until the payment of the principal at the end of a bond’s term. Turnover is limited, therefore the composition of the portfolio at each year of the portfolio becomes critical. As the bonds roll down each year and are paid out, it might be a consideration that the underlying bonds be uniformly diversified within each year in terms of Treasuries vs credit and in terms of quality and sector breakdown. An illustration of a hypothetical portfolio with balanced credit quality can be seen in Illustration 1.

Another important consideration given the limited turnover of the portfolio is the risk of credit defaults. Even though it does not eliminate the risk of credit defaults, ensuring that the bond manager creating the portfolio has capabilities in researching and selecting all types of credit bonds, as well as monitoring them over time, is an important factor.

Finally, it is important to consider the provisions of the pension plan and the liability cashflow profile of the plan. Projected benefit payments are based on underlying demographic assumptions such as retirement age and probability of death, as well as form of payment. Lump sum provisions, a large active population, or cost of living increases can exacerbate the uncertainty of the benefit payment projections, with longer term benefits often more uncertain than near term benefits.

Illustration 1: Sample Cashflow Matching Portfolio by Credit Quality

^{Source: BlackRock. For illustrative purposes only. Not representative of an actual portfolio or client account, nor is this investment advice. Sample liability profile with a duration of 10.1 years and $8.0 Bn in Market Value. Sample portfolio consisting of 74% corporate bonds, 25% government and 1% ABS. Illustrative liability-matching example showing credit quality distribution, not performance or return data. Credit quality refers to the average credit rating as published by the three major rating agencies: S&P Global Ratings, Moody’s Investors Service, and Fitch Ratings. Credit ratings are opinions of the relative credit risk of entities, credit commitments, or debt obligations.}