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The proportion of individuals in defined contribution pension schemes grows steadily. Many Muslims want Shariah compliant pensions, but at present the choices available are limited, due to the absence of Shariah compliant annuities. Their creation would also increase the demand for very long-term sukuk.

Posted 18 April 2016 Updated 19 April 2016

There is a global swing away from defined benefit pension schemes to defined contribution pension schemes.

Accordingly, as Islamic finance develops, it needs to have Shariah compliant products for all the phases of a defined contribution pension scheme. However, at present, as far as I am aware Shariah compliant annuities are not available. Without Shariah compliant annuities, retirees face two risks:

• Spending their pension fund too quickly, so that the money runs out while they are still alive.
• Spending their pension fund too slowly, so that they skimp on themselves in retirement, leaving an unused pot of money to be inherited by someone.

Annuities remove these risks by providing a guaranteed annual income paid for the rest of your life.

I explained the issues in my latest monthly column in the magazine "Islamic Finance News" which is reproduced below. The magazine itself is only available to subscribers.

Letter from Amin 13 April 2016

As Islamic finance develops, it needs to cater for the totality of individuals’ financial needs. One of these is retirement provision. In conventional finance, recent decades have seen a big swing away from private sector employers offering defined benefit pension schemes, which promise a defined amount of pension, often linked to final salary. Employers have realised that these create too much risk for them; a company’s role is to run a profitable business, not to take on financial pension risks which run for decades.

The trend in the private sector is towards defined contribution schemes. These typically involve contributions into a pension fund being made by the employee and the employer which are tax-deductible, followed by the investment of the fund over the employee’s working life, typically growing tax-free, and then retirement. The key question is what to do with the fund on retirement. Conceptually, there are three alternatives.

1. The first is to take out the entire lump sum from the pension scheme. However, if allowed at all by the applicable law, this may involve prohibitive tax costs. It still leaves open the question of what to do with the lump sum afterwards.
2. The second alternative is to leave the fund invested and to make periodic cash withdrawals as the retiree requires money to spend. That is what I have done with my own defined contribution pension arrangements since I retired.
3. The third alternative is use the accumulated defined contribution pension fund to purchase an annuity. The annuity vendor (typically a large insurance company) contracts to pay the retiree an annuity for the remainder of his life. One can choose to have the annuity continue for the retiree’s widow’s life. The annuity may be level, may increase at a fixed rate or may be linked to an inflation index. All of these options are, of course, reflected in the annuity’s initial pricing. Annuities are particularly appropriate for individuals with relatively lower amounts of pension fund or other savings who cannot afford to have the continuing investment risk throughout retirement which the second alternative entails.

For Shariah compliant defined contribution pension funds, one requires a Shariah compliant solution for each of the lifetime stages mentioned above. It is relatively straightforward to set up a Shariah compliant defined contribution scheme into which individuals and their employers can pay. It is also relatively straightforward to provide Shariah compliant alternatives to invest the defined contribution pension fund until retirement, for example using Shariah compliant mutual funds and Shariah compliant sukuk funds.

The area where the market presently appears deficient is the provision of Shariah compliant annuities. When writing on Islamic finance I always leave Shariah issues to others. However, I expect that it should be possible to manage the key actuarial risk, namely longevity risk, using the same takaful concepts applied in the provision of Shariah compliant life insurance. However, there is an economic challenge for potential providers of Shariah compliant annuities. To match the risks of the annuities they will sell, they need to be able to purchase very long dated investments, such as sukuk, with matching characteristics. This requires governments or corporates to issue very long dated fixed rate sukuk and indeed also very long dated index linked sukuk if we are to see the growth of a market in Shariah compliant inflation linked annuities.

The positive side is that if this market can develop, it will offer sukuk issuers very long-term funding at potentially attractive rates.

Addendum

Faizal Manjoo has written the a paper "An Appraisal of Longevity Risk: Conventional and Islamic Perspectives" for the International Shari'ah Research Academy (ISRA), ISRA paper 44/2012. While most of the paper is about longevity risk from the perspective of societies, the paper briefly touches on the question of Shariah compliant annuities on page 59.