Emerging Market Pension Funds and International Diversification

By Pfau, Wade D. | The Journal of Developing Areas, Fall 2011 | Go to article overview
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Emerging Market Pension Funds and International Diversification


Pfau, Wade D., The Journal of Developing Areas


ABSTRACT

Many countries are currently increasing the advanced funding of their public pension systems to improve their sustainability in the face of rapidly aging populations. When pensions are funded, the issue of asset allocation becomes of paramount importance. Standard portfolio selection theory provides a fundamental justification for international diversification: by widening the pool of potential assets, investors can potentially increase returns while possibly even reducing risks through the selection of complementary assets with low correlations. Nonetheless, many emerging market countries have regulations that strictly limit the choice of investments for pension funds, in some cases excluding international assets entirely. This paper uses modern portfolio theory to determine the optimal asset allocation for public pension systems in emerging market countries. We find that on average, about half of the portfolios of emerging market countries should be in world assets. The paper then quantifies the costs of prohibiting international diversification.

JEL Classifications: H55, G11, G23

Keywords: asset allocation, emerging markets, pensions, international diversification

(ProQuest: ... denotes formula omitted.)

INTRODUCTION

Changing demographic conditions are playing havoc on the public pension systems of countries both rich and poor. Traditionally, countries tended to rely on pay-as-you-go pension systems which allowed them to provide pensions to their current elderly using the contributions of the current workforce. These systems tend to work so long as the growth rates of contributors and their productivity exceeds the growth of pensioners. Worldwide, though, reduced fertility rates and increasing longevity are making such systems unsustainable in the sense that promised pension payments to the increasing elderly populations will exceed worker contributions. In response, a number of countries are increasingly shifting their public pension systems from pay-as-you-go toward the inclusion of more advanced funding. For many emerging market countries, these reforms are accompanying efforts to expand pension coverage to a larger portion of the population, many of whom are still not protected by any formal pension schemes. Advanced funding can help to preserve intergenerational equity, potentially provide additional savings for economic development, and allow the pension fund or pensioners to enjoy the benefits of compound interest.

But with the expansion of advanced funding, the issue of asset allocation becomes of paramount importance. Countries must decide how to regulate the choice of potential investments for pension participants (in the case of individual pension accounts) or the centralized pension fund (in the case that pension contributions are accumulated in one central account). To be clear from the outset, the analysis of this paper can be applied to any pension system reform that is not purely pay-as-you-go. There are some different aspects that must be considered for different kinds of pension funding, such as the time schedule of pension payments and the sensitivity of pension payments to inflation and wage growth, but generally the same asset allocation issues apply regardless of whether the system is defined-benefit or defined-contribution, centrally or individually managed, publicly or privately managed, contributory or noncontributory, and mandatory or voluntary. Asset choices potentially include domestic fixed income instruments such as bank deposits or government bills and bonds, domestic equities, or domestic real estate and other alternative assets. International assets are also part of the investment universe, such as foreign government or corporate bonds, equities, or other alternative assets from abroad.

Two basic frameworks exist for regulating the asset allocation of pension funds: quantitative restrictions and prudent person rules. Quantitative restrictions set limits on the amounts of different types of assets than can be held in the pension fund portfolio, while prudent person rules provide more flexibility for the pension fund manager to choose investments in a prudent way as would be done for their own affairs (Davis, 2002a).

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