Emerging Market Pension Funds and International Diversification

Pfau, Wade Donald (2009): Emerging Market Pension Funds and International Diversification. Forthcoming in: 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.

• Item Type: MPRA Paper
• Language: English
• Keywords: emerging markets; asset allocation; pensions; defined-contribution
• Subjects: G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; H - Public Economics > H5 - National Government Expenditures and Related Policies > H55 - Social Security and Public Pensions; G - Financial Economics > G2 - Financial Institutions and Services > G23 - Non-bank Financial Institutions ; Financial Instruments ; Institutional Investors

References

Bank for International Settlements (2007) BIS Quarterly Review, September 2007.

Blake, David (2000), Does It Matter What Type of Pension Scheme You Have?, The Economic Journal, Vol. 110 (February 2000): pp. F46-F81.

Bodie, Zvi, Alex Kane, and Alan J. Marcus (2008) Essentials of Investment. Seventh Edition. Boston: McGraw-Hill.

Bodie, Zvi, and Robert C. Merton (2002), International Pension Swaps, Journal of Pension Economics and Finance, Vol. 1, No. 1, pp. 77-83.

Burtless, Gary, (2007), International Investment for Retirement Savers: Historical Evidence on Risk and Returns. Center for Retirement Research Working Paper 2007-5. Boston: Center for Retirement Research at Boston College.

Chan-Lau, Jorge (2005), Pension Funds and Emerging Markets, Financial Markets, Institutions, and Instruments, Vol. 14, No. 3, pp. 107-134.

Davis, E. Phillip (2002a), Prudent Person Rules or Quantitative Restrictions? The Regulation of Long-Term Institutional Investors’ Portfolios, Journal of Pension Economics and Finance, Vol. 1, No. 2, pp. 157-191.

Davis, E. Phillip, (2002b), Pension Fund Management and International Investment – A Global Perspective, Pensions Institute Discussion Paper 0206.

Hu, Yu-Wei, Fiona Stewart, and Juan Yermo, (2007), Pension Fund Investment and Regulation: An International Perspective and Implications for China’s Pension System, OECD Working Paper, http://www.oecd.org/dataoecd/9/30/39604854.pdf

Iglesias, Augusto, and Robert J. Palacios, (2000), Managing Public Pension Reserves, Part I: Evidence from the International Experience, Social Protection Discussion Paper Series, No. 3. Washington, DC: World Bank.

International Labour Office (1997) Social Security Financing, Geneva: International Labour Office. International Monetary Fund (2008) International Financial Statistics CD-ROM (February 2008), Washington, DC: International Monetary Fund.

Kotlikoff, Laurence J., (1999) The World Bank’s Approach and the Right Approach to Pension Reform, Mimeo. Boston University.

Lewis, Karen K. (1999), Trying to Explain Home Bias in Equities and Consumption, Journal of Economic Literature, Vol. 37, No. 2, pp. 571-608.

Markowitz, Harry (1952), Portfolio Selection, Journal of Finance, Vol. 7, No. 1, pp. 77-91.

MSCI Barra (2008) Global Investable Market Indices. Available at: http://www.mscibarra.com/

Organisation for Economic Co-operation and Development (2008) Global Pension Statistics. Paris: OECD. Available at: www.oecd.org/daf/pensions/gps

Pfau, Wade D. (2009), The Role of International Diversification in Public Pension Systems: The Case of Pakistan, Economic Issues, Vol. 14, No. 2, 81-105.

Reisen, Helmut (1997), Liberalizing Foreign Investments by Pension Funds: Positive and Normative Aspects, World Development, Vol. 25, No. 7, pp. 1173-1182.

Roldos, Jorge E. (2004), Pension Reform, Investment Restrictions, and Capital Markets. IMF Policy Discussion Paper PDP/04/4. Washington, DC: International Monetary Fund.

Roy, A.D. (1952), Safety First and the Holding of Assets, Econometrica, Vol. 20, No. 3, pp. 431-449.

Sharpe, William F., Peng Chen, Jerald E. Pinto, and Dennis W. McLeavey, (2007) “Asset Allocation” in John L. Maginn, Donald L. Tuttle, Dennis W. McLeavey, and Jerald E. Pinto (eds.) Managing Investment Portfolios: A Dynamic Process. Third Edition. Hoboken, NJ: John Wiley and Sons, pp. 230-327.

Solnik, Bruno, and Dennis McLeavey (2004) International Investments, Fifth Edition, Boston: Pearson Addison Wesley.

Srivinas, P. S., and Juan Yermo, (1999), Do Investment Regulations Compromise Pension Fund Performance? Evidence from Latin America. World Bank Latin American and Caribbean Studies Paper. Washington, DC: World Bank.

World Bank (2007) World Development Indicators 2007 CD-ROM. Washington, DC: World Bank.