Optimizing Pension Outcomes Using Target‐Driven Investment Strategies: Evidence from Three Asian Countries with the Highest Old‐Age Dependency Ratio*

• Published date: 01 August 2020
• Date: 01 August 2020
• DOI: http://doi.org/10.1111/ajfs.12310

Optimizing Pension Outcomes Using Target-

Driven Investment Strategies: Evidence

from Three Asian Countries with the

Highest Old-Age Dependency Ratio*

Zefeng Bai**

Department of Mathematical Sciences, Bentley University, United States

Kai Wallbaum

Risklab GmbH, Allianz Global Investors, Germany

Received September 26, 2019; Received in current form (2

nd

revision) June 22, 20 20; Accepted June 24, 20 20

Abstract

As a response to unforeseeable market turbulence—such as the 2008 financial crisis and the

most recent market drawdown triggered by the COVID-19 pandemic—we propose a new pen-

sion investment strategy that could better protect a long-term pension plan in volatile market

conditions. Over a hypothetical 20-year pension scheme and various target volatility scenarios,

we show that our newly proposed strategy, which attaches a target volatility mechanism to a

lifecycle strategy, could provide more effective capital protection and risk control for pension

investment vehicles. Our results are robust with a consideration of transaction costs.

Keywords lifecycle concept; pension; risk management; target volatility

JEL Classification: G31, G32

1. Introduction

How to optimize pension outcomes for pension plans in volatile markets? This is a

question that has been debated, internationally, by both scholars and practitioners.

Over the past several decades, various investment strategies have garnered signifi-

cant attention in pension discussions. For example, different time-series momentum

strategies (Baltas and Kosowski 2013), risk parity approaches (Kazemi 2012), and

target-date pension investment strategies have become important in financial invest-

ment practice due to their suitable asset allocation concepts in response to rapidly

changing market conditions (Forsyth and Vetzal 2019). Under most target-date

*We would like to express our deepest gratitude to Prof. Victoria Steblovskaya at Bentley

University for her suggestions and guidelines in the creation of this manuscript.

**Corresponding author: Bentley University, Waltham, MA 02452, USA. Tel: +1-973-609-

9096, email: zbai@bentley.edu.

Asia-Pacific Journal of Financial Studies (2020) 49, 652–682 doi:10.1111/ajfs.12310

652 ©2020 Korean Securities Association

pension concepts, investors benefit from the embedded asset allocation process,

which reduces risky assets when the retirement date nears. Prior research has shown

that a simple target-date pension strategy often outperforms other investment

strategies and can generate better pension outcomes in various market scenarios

(Bodie and Treussard 2007; Elton et al. 2015). As one of the most commonly used

target-date pension strategies, the lifecycle pension management strategy has

become an important pillar of old-age provision in the United States and Europe.

In the foreseeable future, the lifecycle concept will also play a more critical role in

other global pension markets.

Motivated by the most recent global financial market drawdown caused by the

COVID-19 pandemic (Baker et al. 2020) and the low expected market return envi-

ronment (Horneff et al. 2018), we propose a new combined pension management

strategy that aims to improve the traditional lifecycle pension investment concep t

in different market conditions. To develop this new strategy, we attach a dynamic

risk management overlay called the target volatility mechanism to a simple lifecycle

pension strategy as an additional investment protection mechanism for pension

portfolios in more volatile markets. We set up a 20-year hypothetical pension

scheme and conduct corresponding analyses based on historical time series to com-

pare the performances of two pension strategies—the simple linear lifecycle pension

strategy (hereafter referred to as the lifecycle strategy) and the simple linear lifecycle

pension strategy with the target volatility overlay (hereafter referred to as the target

volatility strategy or the combined strategy) in three investment regions: Japan,

China, and South Korea. We focus on these three countries because they are pro-

jected to have the highest old-age dependency ratio by 2050 (United Nations 2019).

We believe that proposing a suitable pension investment strategy for them could

help reduce the financial burden placed on their working forces as a result of sup-

porting the old-age population in the future. Our numerical results suggest that the

target volatility strategy could lead to higher portfolio returns in these three Asian

markets. More importantly, we also find that the target volatility strategy could pro-

vide effective capital protection when a pension portfolio encounters market turbu-

lence, such as the 2008 financial crisis, and that it could reduce the overall portfolio

downside risk over the hypothetical pension scheme. Consequently, we find that the

target volatility mechanism could improve various pension outcomes and offer

effective capital protection when combined with the lifecycle pension strategy.

2. Literature Review

For decades, one of the most widely used pension strategies has been the lifecycle

pension strategy, which belongs to the target date concept family. The lifecycle pen-

sion strategy reduces the risky asset exposure of a pension portfolio as it approaches

the “target date” (Graf 2017) so that the pension portfolio is secure as a future

retiree approaches retirement age. Benefits of the lifecycle pension strategy have

been well documented. Prior studies have shown that pension investors benefit

Optimizing Pension Outcomes Using Target-Driven Investment Strategies

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