This brief tailors life-cycle fund designs to emerging markets by factoring in human capital risk, market volatility, and local demographics, using case studies from Mexico, Poland, South Africa, and Turkey.
Overview
Over the past two decades, defined contribution (DC) pension plans have largely replaced defined benefit (DB) plans worldwide, including in emerging market (EM) countries, where DC plan assets account for approximately 90% of total pension investments. A key challenge with DC plans is that participants often struggle with making optimal investment decisions due to financial illiteracy or behavioral biases, increasing the risk of insufficient retirement savings.
Support Research for the Global Investment Community. Your donation raises professional excellence and enables the foundation to continue its important mission to fund, publish, and distribute in-depth, high quality, independent research.
To address this issue, DC pension plans often provide default investment options, which are automatically selected when plan members do not actively choose an investment strategy. Among these, life-cycle funds, also known as target-date funds, have become a widely adopted default option. These funds gradually reduce equity exposure as investors approach retirement.
While widely used in the United States, life-cycle funds should be tailored to EM countries due to differences in demographic structures and financial market conditions. In this respect, this study examines the optimal design of life-cycle funds for Mexico, Poland, South Africa, and Turkey by incorporating risky human capital and parameter uncertainty.
Key findings include the following:
- Labor income profiles and capital market assumptions significantly impact life-cycle fund allocations.
- Risk aversion, permanent income shocks, and the correlation between human capital and stock returns strongly influence investment strategies. When human capital and stock returns are highly correlated, younger investors may benefit from higher bond allocations, with stock allocations increasing later in life.
- Contribution rates and discount rates have a relatively limited impact on asset allocations.
- Parameter uncertainty leads to more-conservative equity allocations, particularly in countries with high stock market volatility.
Policymakers and pension fund managers in EM countries should design life-cycle funds that account for country-specific labor income profiles, sectoral variations, and parameter uncertainty. Moreover, robust regulatory frameworks and financial literacy initiatives are essential to support cost-effective default options that reflect local economic conditions and investor behavior.