Emerging Market Pension Funds and International Diversification

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.