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Emerging Market Pension Funds and International Diversification

  • Wade D. Pfau

    (National Graduate Institute for Policy Studies)

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. Through compound interest, the rate of growth for pension fund assets will have enormous implications for the level of pension contributions that will be needed to fund a desired level of benefits. 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 seeks to determine what economic theory suggests is the optimal asset allocation for public pension systems in emerging market countries, and in particular, what role international assets play in the optimal portfolios. 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.

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Paper provided by National Graduate Institute for Policy Studies in its series GRIPS Discussion Papers with number 08-10.

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Length: 18 pages
Date of creation: Sep 2008
Date of revision:
Handle: RePEc:ngi:dpaper:08-10
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  1. World Bank, 2007. "World Development Indicators 2007," World Bank Publications, The World Bank, number 8150, August.
  2. Reisen, Helmut, 1997. "Liberalizing foreign investments by pension funds: Positive and normative aspects," World Development, Elsevier, vol. 25(7), pages 1173-1182, July.
  3. Blake, David, 2000. "Does It Matter What Type of Pension Scheme You Have?," Economic Journal, Royal Economic Society, vol. 110(461), pages F46-81, February.
  4. Karen K. Lewis, 1999. "Trying to Explain Home Bias in Equities and Consumption," Journal of Economic Literature, American Economic Association, vol. 37(2), pages 571-608, June.
  5. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
  6. Bodie, Zvi & Merton, Robert C., 2002. "International pension swaps," Journal of Pension Economics and Finance, Cambridge University Press, vol. 1(01), pages 77-83, March.
  7. Davis, E. Philip, 2002. "Prudent person rules or quantitative restrictions? The regulation of long-term institutional investors' portfolios," Journal of Pension Economics and Finance, Cambridge University Press, vol. 1(02), pages 157-191, July.
  8. Jorge A. Chan-Lau, 2004. "Pension Funds and Emerging Markets," IMF Working Papers 04/181, International Monetary Fund.
  9. Gary Burtless, 2007. "International Investment for Retirement Savers: Historical Evidence on Risk and Returns," Working Papers, Center for Retirement Research at Boston College wp2007-05, Center for Retirement Research, revised Feb 2007.
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