Optimal Design of Life-Cycle Funds in Emerging Markets

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.