Cash Flow Matching Strategy for Pension Fund Liabilities

ABC Asset Management has been tasked with managing a fixed-income portfolio that aligns with the future liabilities of a pension fund. The fund has a series of cash outflows expected over the next 15 years: $2 million due in Year 1, $3 million due in Year 3, and $5 million due in Year 5. The portfolio manager considers cash flow matching strategies using various bonds.

The manager considers three bond options for cash flow matching. The first option is a 3-year zero-coupon bond with a face value of $3 million maturing at the end of Year 3. The second option is a 5-year coupon bond paying a 5% annual coupon, with a face value of $5 million maturing at the end of Year 5. The third option is a combination of a 1-year zero-coupon bond with a face value of $2 million maturing in Year 1, along with the 5-year coupon bond described above.

Given the above information, which cash flow matching strategy should the manager primarily use to ensure adequate liquidity for the fund's liabilities?