62 June 2014 www.meinsurancereview.com

Takaful feaTure: IslamIc pensIons

One of the biggest problems that the world has to address is the issue of ageing populations. Based on the forecast of the United Nations and other

research done, the world will have more elderly people than young people by 2045. In the developed world, such as the OECD countries, life expectancy has consistently increased. A similar forecast is being made for the Muslim world (World Demographic and Ageing Population Report, 2010), but its manifestation will be at a faster rate.

Traditionally, it is the pension industry that caters to post-retirement funding. However there are some prohibited elements in conventional pensions, as in the case of insurance and banking, that dictate the development of an Islamic version of pension.

Funded and unfunded pensionsPension is often considered as a retirement savings plan which is a long-term investment (10 years or more) that aims to build a fund for someone’s retirement in a tax-efficient way. There are two types of pension: the funded and the unfunded.

The funded pension is one whereby both the employee and employer contribute towards the

pension pot for the individual employee. The unfunded pension is one whereby the employee contributes a sum of money and the employer, usually the government, will guarantee him or her an annuity after his or her retirement without contributing anything. Usually, the unfunded pension is supported by the contributions from the next generation. The main purpose of pension is to facilitate consumption smoothing, ie, after retirement a pensioner can keep up a more or less same standard of living by balancing his savings and spending during his working life. The contribution is invested in such a way that the impact of inflation on the savings is stomached and also some excess profit is generated.

Types of pension arrangementsThere are two main pension arrangements or plans: the defined benefit and the defined contribution. The defined contribution pension is an arrangement whereby the

Addressing the needs of the ageing

Sheikh Faizal A Manjoo of Markfield Institute of Higher Education suggests ways of eliminating elements prohibited in Islam and making pensions Shariah compliant.

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www.meinsurancereview.com June 2014 63

Takaful feaTure: IslamIc pensIons

employee knows how much annuity he will receive upon retirement. The emphasis is on the contribution to be paid and not the annuity. The risk in the case of defined benefit lies with the employer who has to ensure that the benefit is met by sponsoring the pot, while in the case of defined contribution, the risk lies with the employee who contributes to a funded pension plan and advises where he wants his money to be invested. If there is a market crash, the employee faces the risk of getting nothing.

Due to this risk dichotomy, the tendency in countries like Holland and the UK now is to develop a defined ambition arrangement, a hybrid of these two arrangements whereby the pension provider promises to pay the employee a minimum lump sum and the rest of the risk is shouldered by the employee, depending on the performance of his pot.

Why are conventional pensions prohibited in Islam? From an Islamic point of view, there are a few problems with the defined benefit and the annuity to be paid. The defined benefit arrangement formulates a fixed amount for the employee in exchange for contributing to a pot which technically is not his. Usually, the money is kept in a trust.

Muslim scholars’ views are that if the defined benefit is considered as a deferred salary package, whereby the employee has no control over the pot, just like the case of a provident fund, then such an arrangement is permissible. If it is considered a contractual agreement, it will attract riba (interest), gharar (excessive uncertainty) and maysir (gambling), because one is receiving more than what he contributed. There is the element of gharar because he does not know for how long he will be alive to benefit from the arrangement pension, and the element of maysir because the pension provider speculates that the pensioner will not live long and he is gambling on this based on a morbidity table. The same line of reasoning applies in the case where an annuity is purchased from the lump sum received after retirement.

In some countries, it is mandatory to buy an annuity. In the UK however, there is a move to not making the purchase of annuity mandatory from 2015. The implication is that if people do not buy annuities, they will have to pay early tax on the lump sum they receive upon retirement and also the risk of squandering the money is always there for those who do not have a vision to save. This was the case in Malaysia, where surveys have showed that on average, people tend to spend their lump sum in a short period of three years.

Models of Islamic pensions To eliminate these prohibited elements, contractual

engineering done in the case of takaful can be emulated in pensions, ie, to develop a product whereby a bilateral contract is converted into a unilateral contract via the concept of tabarru’, or donation.

It is an established principle under Islamic law that a unilateral contract does not attract riba, gharar and maysir. Keeping this principle in mind, many models of Islamic pension arrangement can be developed. In this article, we will briefly discuss two models: an occupational Islamic pension model and a personal Islamic pension model.

In the case of the occupational model (which is technically a defined contribution), the employee makes a donation to the pension pot and this is further subsidised by the employer. They make a wa’ad iltizami (binding promise)

to consistently contribute to the pension fund. The contributions are invested by the pension operator who acts as a wakeel (agent in managing the pension pot). This is the accumulation phase of the pension fund. A few years before the annuity is to be paid by the pension provider, the de-risking phase starts, ie, the pension pot must contain more liquid instruments rather than long-term investments. The pension fund will make a wa’ad iltizami to look after the pensioner by paying him a lump sum every month till his death, as actuarially calculated. In this way, there are two promises: one by

the participants to contribute into the pension fund by donations and the other one is the promise by the pension fund to make a donation to the pensioner after his retirement.

In the case of a personal pension fund, the issue is quite straightforward in that the pension pot rests within the control of the contributor. When the time to retire comes, he can make a draw down, i.e. he can withdraw partially from the fund while the balance remains as an investment in the pot.

A debate that cropped up recently concerns the Islamic voluntary sector (ie, the responsibility of Muslims to help the needy). One of the maqasid (goals or purposes) of the Shariah is the protection of human dignity, which is often neglected in the literature. The establishment of awqaf to look after the elderly can also be considered as an alternative for helping the needy elderly people.

Product innovation and marketing are necessary Islamic pensions was estimated to be worth $22 billion in 2013, an amount that warrants investigation. Product innovation and marketing need to be carried out to enhance this branch of takaful.

Sheikh Faizal A Manjoo is a Lecturer in Law & Finance with Markfield Institute of Higher Education.

Contractual engineering done in the

case of takaful can be emulated in

pensions, i.e. to develop a product

whereby a bilateral contract is

converted into a unilateral contract

via the concept of tabarru’, or

donation. It is an established

principle under Islamic law that a

unilateral contract does not attract

riba, gharar and maysir.

Tak_Pensions.indd 63 22/5/2014 15:10:36