By the end of 2019, the Mexican pension system underwent an important reform regarding the investment strategy of its mandatory defined contribution plans. Implementation of this reform requires a transition from a multi-fund model to a single target-date fund (TDF) design in the investment regime for SIEFORE’s (mutual funds specialized in pension funds). Under TDFs, each worker’s savings are assigned to the SIEFORE that is linked to his/her date of birth and are accumulated there during his/her entire working life. By doing so, TDFs provide a mechanism to automatically reduce the proportion of the portfolio held in stocks as a worker/investor ages.

Although a common feature of TDFs is that they reduce equity allocation as investors age, the financial services industry uses different approaches to calculate optimal equity allocation by age.

In this context, some studies have emphasized the role of human capital and its’ risk in estimating the optimal equity allocation in TDFs (Cocco et al., 2005; Viceira, 2010). This requires considering differences in workers’ age-earnings profiles and incorporating temporary and permanent shocks to labor income in modeling human capital for each country.

The purpose of this study is to develop a new TDF model for the Mexican pension system reflecting the demographic and financial structure of the country. In this respect, firstly, a stochastic human capital is modeled for Mexican households according to the methodology of Campbell and Viceira (2002) and Cocco et al. (2005).

Then, portfolio allocations of TDFs are estimated based on the human capital structure that is both stochastic and correlated with stock returns. The main findings can be summarized as follows:

• Human capital risk and its correlation with stock returns play a particularly important role in the design of TDFs.
• As the correlation between human capital and stock returns becomes more negative, the optimal stock allocation for each age group increases.
• When the positive correlation between human capital and stocks reaches 30%, the optimal allocation to stocks becomes 0, except for the earliest age group.

The findings may have important implications for workers under the Mexican pension system who have a strong correlation between his/her human capital and stock returns. For example, if an employee in the construction industry has a portfolio of stocks mostly belonging to the construction industry, then there is a positive and strong correlation between the human capital and stock returns for that employee. In this context, such an employee should have a very different stock allocation compared to the classical TDFs offered in Mexico.

To review the study in detail, you can download it here.