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CONTENTS

Introduction
The needs for retirement planning

Definition of retirement planning
Retirement planning process

Setting of retirement plan goals
Obtain information to determine retirement needs
Analyze information and calculate savings needed
Plan the distribution, ascertaining the best method for the client to distribute
Implement the plan
Review the plan

Availability of non-funded “safety nets”

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CONTENTS (Cont’d)

Investment structure for retirement

Riba
Risk vs return

Risk factors
Islamic view on risk management

Portfolio theory applied to retirement planning

Modern portfolio theory
Diversification
Taxation
Asset allocation

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CONTENTS (Cont’d)

Property as an asset class

Characteristics
Permissible Islamic mortgage
Taxation
Risks

Retirement scheme

Types of retirement plans

Pension schemes
Products and service support for pension scheme
Profit Sharing schemes
Share option schemes
Allotment of shares to employees
Special gratuity scheme

Benefit Design
Security of fund

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CONTENTS (Cont’d)

Provident fund and other retirement schemes

Malaysia’s Employees Provident Fund

History and development
Features of the scheme
Benefits under the scheme
Relevant legislation and guidelines

Retirement plan in the USA

Payroll deduction IRA plan
Simple IRA plans
Simplified Employee Pension (SEP) plan
Defined contribution plans
The fallacy of ERISA

Pension systems in Middle East and North Africa (MENA)
Australia’s Superannuation plan
Canada’s RRSP

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CONTENTS (Cont’d)

Streaming Retirement Income

Definition of income stream
Vehicles providing income streams

Pension
EPF
Takaful or life insurance
Health insurance
Annuities
Fixed deposit income
Income from unit trust funds or mutual funds
Income from shares
Income from properties

Discounted cash flow

Summary

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INTRODUCTION

Retirement Planning is one of the significant parts in the financial planning process as this will create a significant source of income during the retirement period. It plays a major role in the financial arrangement of a person’s final stage of life.
Although all wealth belongs to Allah, man has been created as vicegerent on earth to use the wealth responsibly to attain success in this world and the next

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INTRODUCTION (Cont’d)

Good wealth management is encouraged in Islam as any possession of assets or wealth would not prosper without any planning and implementation.
Hence retirement planning as a wealth protection measure in the component of contemporary financial planning applies to Muslims as well.
Nevertheless, for Muslims, the concept of Islamic financial planning must be added, i.e. by adding that all planning above must comply with Shariah requirements.

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INTRODUCTION (Cont’d)

Contemporary financial planning encompasses

wealth creation (earning income or working);
wealth accumulation (investing, saving);
wealth protection (retirement planning, insurance); and
wealth distribution (taxation, charitable and planned giving).

From Islamic viewpoint, we need to add

Wealth purification (zakat, waqf, donations, gifts, etc)

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INTRODUCTION (Cont’d)

Retirement schemes in Malaysia and in most developing countries are not very advanced.
The Employees Provident Fund (EPF) is the most notable scheme in Malaysia. Although this used to be for non-government staff, it has now become more dominant even for government staff.
Some corporate organizations create their own retirement schemes as part of staff retention scheme
Despite the obvious need of a retirement plan, many do not seem to take this seriously

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THE NEED FOR RETIREMENT PLANNING

Proper retirement plan is very much needed in case we live long enough that we may exhaust our savings
The “retirement risk” is as critical as “premature death”. Both are real but only one can happen in one’s lifetime.
A person’s income needs change depending on what stage they are at in their life cycle. The investment portfolio of a middle aged couple, for instance, who don’t have any other dependents, would concentrate on conservative investments such as certificates of deposit (money market or fixed deposit); they would need to consider growth-oriented investment products that will appreciate over time and stay ahead of inflation at preferably minimal risk levels.

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THE NEED FOR RETIREMENT PLANNING (Cont’d)

On the other hand, a young single adult may not even worry about retirement yet and would depend totally on their employers’ retirement scheme, government relevant pension scheme or the national provident fund as the means of retirement savings.
If we want our retirement to be anything like our dreams of leisure and security, it is clear we have to plan carefully to make sure we will have the resources we need.

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THE NEED FOR RETIREMENT PLANNING (Cont’d)

The prospect of a comfortable retirement is like the proverbial carrot dangling in front of us, encouraging us to keep going in hopes of a future reward. The only difference is that, unlike the carrot that is always just too far away to reach, a comfortable retirement is actually attainable.
While this is encouraging, achieving your retirement goals will not happen automatically. As with most other things, the two key things that you need to do are to plan ahead and to have the self discipline and self motivation to follow through with your retirement goals.

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Definition of Retirement Planning

According to the American Heritage Dictionary, “retirement” means the stage of being retired from one’s business and occupation.
Retirement Planning is a comprehensive analysis of the tax-effective strategies which are available to assist you in achieving your goals for retirement.
The retirement planning process includes a comprehensive review and analysis of your assets, liabilities, savings patterns and investment strategy in the context of your timing of your retirement, retirement income and your tolerance for investment risk.
The goal of Retirement Planning is to coordinate the financial resources available so an individual can plan for a financially secure retirement. The retirement planning process teaches you how to calculate the amounts necessary for you to meet your personal retirement goals.

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Retirement Planning Process

There are six steps in formulating retirement planning needs and they are known as the six stages of the retirement process
Setting of retirement plan goals

Formulate retirement goals and determine the life style desired in retirement. Similar to personal financial plan, a retirement plan must have goals which are specific, realistic and in measurable terms i.e. the amount required and the time parameter. At this stage, priorities for planning are established, such as the date of retirement, lifestyle change, any residence change, risk tolerance and planned employment after retirement, if the need may arise.

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Retirement Planning Process (Cont’d)

Obtain Necessary Financial Information to Determine Retirement Needs

All pertinent financial information should be obtained, which also include financial statement, net worth statement, budget, required retirement income, and resources that will be available to provide the income stream at retirement.
The interest and inflation rate to be used in the assumption in the calculation must also be determined.
Based on the goals formulated in the first step above and the information collected, you should be able to determine the savings required and if sufficient assets are available to meet the retirement income needs.
If assets are not available, a savings program is developed to make up for the short-fall. However, if the savings program is not realistic, then go back to step 1 to re-evaluate needs and priorities.

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PHASES OF RETIREMENT AND RETIREMENT PLANNING PROCESS

PHASE 1. ACCUMULATION: BEGINS WHEN WE ENTER THE WORKFORCE
PHASE 2. PRE-RETIREMENT: FINAL YEARS OF ACCUMULATION PHASE IDEALLY AT 50 YEARS OLD OR 15 YEARS PRIOR TO RETIREMENT
PHASE 3. EARLY-RETIREMENT: FROM DAY OF RETIREMENT UNTIL AGE 70
PHASE 4. MID-RETIREMENT: BEGINS AGE 70 AND LAST AS LONG AS ABLE-BODIED AND HIGH FUNCTIONING, ONE MEMBER OF A COUPLE WILL BE THE PRIMARY CARETAKER FOR THE OTHER WHOSE HEALTH IS DECLINING.
PHASE 5. LATE REITEMENT: HEALTH TAKES A TURN TO WORSE, NEEDS HELPER TO TAKE CARE OF YOURSELVES.

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Retirement Planning Process (Cont’d)

Firstly, to assess his financial objective i.e. the person’s future income need. This need varies from person to person; the need is smaller should a person just want to survive. However if the person requires an ambitious retirement plan, then the funds to be created is greater. Hence it is important to forecast a person’s income needs in line with the type of retirement or lifestyle he desires. At this stage, the sources of fund to meet these needs will have to be identified.
The two methods that compute future income needs are:

Replacement Ratio Method
Expense Method

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Retirement Planning Process (Cont’d)

Replacement Ratio Method

This method assumes that changes in the cost of living will be reflected by changes in the individual’s income, and the post-retirement income needs can be estimated from the individual’s pre-retirement income. The standard of living prior to retirement is therefore the determining element in the standard of living post retirement.

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Replacement Ratio Method (Example)

Mr. Syed Umar is currently 38 years old. He plans to retire at 55 and would like to have a retirement income from the age 56 onwards of an amount equivalent to 70% of his last drawn salary at 55, shortly before retirement.
Presumably some of the expenses he requires as a working person would not be needed anymore as a retiree, such as:

Income tax
Office clothing
Maintenance of 2 cars (as retirees, husband and wife will maintain only 1 car)
Travel/commuting costs
Home mortgage repayments (mortgage fully paid by then)
Dependent children (all would be working by then)

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Replacement Ratio Method (Example)

Also, as a retiree, Syed Umar would be enjoying senior citizen rates for some public related expenses.
However, on the other hand, the following costs would escalate with age:
Medical costs
Travel / vacation / lifestyle changes
As an IT analyst, he now draws a monthly gross income of RM8,000 per month; he assumes his income will grow at the rate of 5% per annum until the age of 55. Using future value calculation, his salary at age 55 prior to his retirement would be RM18,336 per month (term, n = 17; rate, r = 5%, pv = 8000*12, bgn mode).
Taking 70% of this would make his requirement for retirement to be approximately RM12,835 per month. This may seem exorbitant by today’s standard and may even appear that Syed Umar will have a luxurious retirement. However, inflation has to be taken into consideration over the 17 year period.

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Replacement Ratio Method (Example)

The advantages of this method are:

Simple to calculate
Easy to relate to
The standard rate of living assumed can be reasonably accepted.

The disadvantages of this method are:

The figure might be excessive in future value (an average income for the 3 years prior to retirement is used to lower this).
There may be some inaccuracies in variables used (e.g. rate of salary increment).

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Expense Method

This method constructs a budget for post-retirement living. The budget consists of basic requirement such as housing costs, food, clothing, and other necessities e.g. medical expenses, etc. The budget would be tabulated more accurately the closer the person is to retirement age.

Mr. Syed Umar from Example 1 above would need to list out all the expenses he may need during his retirement years, i.e. from age 56 onwards, as per the table below:

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Expense Method (Cont’d)

Expenses	Monthly in current RM	Yearly in current RM
Food House insurance (takaful) House assessment/quit rent Utilities (Electricity, telephone, water, ISP, etc) Home maintenance (repair, gardening) Clothing and personal care (both husband & wife) Medical expenses (general check up with GP, dentist) Transportation (car, petrol, parking, toll, road tax, insurance) Entertainment Hobbies (club fees) Travel (once overseas and twice locally) Personal insurance (takaful) Miscellaneous TOTAL	1000 200 500 200 200 600 200 300 200 500	12000 2400 1000 6000 3000 2400 2400 7200 2400 3600 16000 2400 6000 66,800

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Expense Method (Cont’d)

In today’s RM terms, Syed Umar would need RM66, 800 per annum to have a comfortable retirement, as listed out by him. Taking account of inflation of 4%, RM66,800 would become RM130,120 i.e. double today’s value. Hence, the value RM130, 120 per annum, or RM10, 843 per month should then be used in the calculation of the amount required at Syed Umar’s retirement.

The figure RM10, 843 per month of the expense method looks smaller than the RM12,835 calculated in the replacement ratio method above. This is mainly attributable to the fact that as Syed Umar’s salary increases, his saving rate increases as well, and his expenses probably increase at a much slower rate. This is where the expense method is superior when compared to the income replacement ratio method.

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Expense Method (Cont’d)

The advantages of this method are:

More accurate in determining retirement needs.
May be more convincing as actual costs are being worked out to illustrate the actual need during retirement.

The disadvantages of this method are:

It is a tedious exercise to compute the final figure, as it entails listing the expenses.
Some assumptions may not be accurate (e.g. inflation rate; in reality not all expense items inflate at the same rate. To mitigate this, inflation rate can be applied individually to each expense item before coming to the total figure, which of course makes the exercise more time consuming).
There is a tendency to miss out some peculiar expense item which may not be obvious in the present times. For example, 30 years ago, we would not have imagined having to pay for internet fees or pay-tv services.

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�Analyze Information and Calculate Savings Needed to Meet the Objectives�

The calculation of retirement fund to meet objectives is based on various funding sources and the workings of current asset and/or future cash flows, taking account of time value of money.
The financial planner would need to work out the following processes:

a) Determine the lump sum retirement goal required at retirement age

The following information is needed in making these determinations:
A cash flow statement showing the client’s current annual sources and uses of cash.
An annual budget listing present income and projected income at retirement.
Review all available assets that will be utilized to meet retirement needs.

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Analyze Information and Calculate Savings Needed to Meet the Objectives (Cont’d)

By using a worksheet list out the categories of assets that will be valued, such as:-

Real Estate - the value of property sold at retirement must be determined taking into consideration the inflation rate and appreciation value of the property based on location and other factors. Taxes due such as Real Property Gains Tax (RPGT) must also be considered.
Investment Assets - these are investments currently owned which will be sold during retirement to provide additional funds. It may include investment in the Unit Trust funds or stocks and bonds or even equities in non-listed companies.

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Analyze Information and Calculate Savings Needed to Meet the Objectives (Cont’d)

Retirement Income Sources such as the Employees Provident Fund (EPF), pension or annuity. This may include deferred compensation payments, monthly income from company sponsored plans or Trust etc.
Savings Program – include all regular savings and other savings such as Fixed Deposits, Savings or Al-Wadiah accounts, Amanah Saham Bumiputera (for Bumiputera), Tabung Haji accounts and Cash value from Takaful or Insurance.

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Analyze Information and Calculate Savings Needed to Meet the Objectives (Cont’d)

b) Calculate the future value (e.g. age 55 for Syed Umar as in Examples 1 and 2) amount of current funding vehicles such as the EPF, endowment policies, shares, properties and other invested assets which are used to fund the amount in a) The rates of return would vary with each funding vehicle.

c) If the amount in b) exceeds the requirement in a), then the client has sufficient funds to fulfill his retirement needs. However, if the amount in b) is below a), then there is a gap to fill in order to meet his retirement funding. The financial planner would now need to review the client’s financial health to see if there are other areas where this shortfall could be met.

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Analyze Information and Calculate Savings Needed to Meet the Objectives (Cont’d)

In other words, once the goal is determined, the planner seeks for sources of funding and determines the methods to accumulate the fund.
Other factors that must also be considered by planner and client in the retirement planning calculations are:-

Long term assumed inflation rate
Duration of time before the retirement date
How many years to project for retirement?
Income tax rate, before and after retirement.
After-tax return on each investment.

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Plan The Distribution, Ascertaining The Best Method To Distribute That Is Best For The Client.�

Time value of money must be factored when doing the calculations. In most cases, the numbers that result from the calculations are large and shocking. In this case, a realistic plan that can be adopted by the client must be determined. The plan must also take into consideration priorities and risk tolerance of the client.
Depending on whether the client has accumulated sufficient capital, either one of these methods can be selected:

Capital Retention Method / Principal Intact Method; or
Capital Liquidation Method

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Capital Retention / Principal Intact Method

This method is applied if there is sufficient accumulated capital which can generate investment income. The capital will be conserved while the client receives regular income.
This is normally the preferred method as the retiree would not have to worry about outliving his savings.

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Capital Retention / Principal Intact Method (Cont’d)

Ms Aleya wants a retirement income of RM5,000 per month with principal intact.
We need to calculate the lump sum needed for capital retention. First, assume that the lump sum is parked in an Islamic investment vehicle where it is conservative and fairly safe, giving a steady and secure return, e.g. Malaysia’s ASB, giving a long term income of 7%.
The amount of principal required without liquidating the principal itself is 5000 x 12 / 7% = RM857,143

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�Capital Liquidation Method�

This method is applied if the capital accumulated is not sufficient to serve his retirement days. Hence, the earnings as well as the principal would have to be distributed over the estimated life span of the client.
Ms Aleya above will need less principal amount if she is required to liquidate the principal amount. Assuming her retirement age to be 55 and will live to age 85, she will have 30 years to spread the principal amount together with any income or investment earnings.

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Capital Liquidation Method (Cont’d)

Using time value of money, calculate PV (Pmt=5000*12, term n=30, r=7%, bgn mode). The amount of lump sum needed is RM796,660 which is lower than the capital retention method.
Although the amount is lower, should Aleya outlive the age of 85 she would have trouble maintaining her lifestyle as all her savings would now be used up.
N.B. We have not considered inflation on the RM5000 per month.

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Capital Liquidation Method (Cont’d)

In mathematical terms, the principal reduction will be less in the earlier years as the investment income forms the bulk of the pay out. However nearing the end of the consumption years (i.e. 30 years in this example) the principal reduction will be higher than the income as the principal amount itself cannot maintain a high rate of income.
A prudent financial planner will always recommend the capital retention method, unless the lump sum to be accumulated is too big or too impossible to achieve.

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DISCOUNTED CASH FLOW CALCULATIONS Pre-retirement

It should be noted that the calculations for the pension funds or future income have to be calculated based on discounted cash flows to reflect the changes in money value.
Ali’s retirement plan is to have a lump sum of $2million. He is currently 36 years old and would like to retire at age 55. Assuming the pre-retirement rate of return is 8%. Calculate:

a) the pre-retirement funding income stream needed at the beginning of each period, if the income stream are flat annually; and
b) the first income stream if such income stream increase by 10% per annum.

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DISCOUNTED CASH FLOW CALCULATIONS Pre-retirement

It should be noted that the calculations for the pension funds or future income have to be calculated based on discounted cash flows to reflect the changes in money value.
Ali’s retirement plan is to have a lump sum of $2million. He is currently 36 years old and would like to retire at age 55. Assuming the pre-retirement rate of return is 8%. Calculate:

a) the pre-retirement funding income stream needed at the beginning of each period, if the income stream are flat annually; and
b) the first income stream if such income stream increase by 10% per annum.

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DISCOUNTED CASH FLOW CALCULATIONS Pre-retirement

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DISCOUNTED CASH FLOW CALCULATIONS Pre-retirement

2 steps
B 1)

FV = PV (1 + r)

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DISCOUNTED CASH FLOW CALCULATIONS Pre-retirement

B2) calculate growth adjusted discount rate, given investment rate is 8% and annual contribution growing at 10%
Adjusted rate = r-g/1+g =.08-.10/1.10 =-.0181818

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Implement the Plan

This step may involve gathering other professionals (e.g. lawyers, insurance agents, tax consultants), depending on the complexity of information.

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�Review the Plan�

Each plan should be reviewed at least annually to be sure that goals are being met and to make any necessary changes, if necessary.

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�Availability of Non-Funded “Safety-Nets”�

There are three broad sources of funding the retirement need of an individual.

In Malaysia, there are hardly any non-funded “safety nets” other than

Aids from the government e.g. assistance on welfare or humanitarian grounds
Aids from non-government organizations (NGOs)
Extended family concept, where relatives or children of the retiree financially support him during his retirement years.

For most people in Malaysia, EPF forms the main source of retirement fund. However, there are now many schemes in which withdrawals may be made from one’s EPF account to reduce the financial burdens in the present day, such as, mortgage repayments, purchase of computers, medical expenses;
Singapore’s CPF allows individuals to withdraw for insurance premiums. Although the intentions are to reduce expenses in today’s living, we are at risk of depleting one of our main financial resources in our golden years.

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�INVESTMENT STRUCTURE FOR RETIREMENT�

While many financial planning strategies are geared towards wealth maximization, there comes a time when people look toward investment and a possible fundamental shift in their approach to investing.
Many people do not want a reduced standard of living at retirement. It is important to have pre-retirement funding properly invested so that the amount accumulated at the time of retirement will meet the original goal. One can enjoy his retirement by analyzing his income needs and be aware of how annuities or the cash values of Takaful can increase his retirement income.
The financial needs of a Muslim need not be dissimilar to that of a non-Muslim, but for the fact that the needs should not transgress what is dictated by Islam. The satisfaction of these needs should adhere to the teachings of the Qur’an and Sunnah, hence gaining Allah’s blessing and barakah .

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INVESTMENT STRUCTURE FOR RETIREMENT (Cont’d)

Muslims need to avoid riba completely

Risk vs Return
Risk factors
Personal Risk

Events such as critical illness, a major medical disability or accident that may require the use of funds originally saved up for retirement. To overcome this risk, the risk management tool of personal insurance or Takaful should be taken up.

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INVESTMENT STRUCTURE FOR RETIREMENT (Cont’d)

Property risk

A major loss in uninsured personal assets such as home or car can affect one’s retirement fund. To overcome this risk, property insurance is taken up.

Liability risk

The possibility of being sued by some third party may seem a highly unlikely event, but it is still wise to have some form of personal liability insurance, especially if one owns a business or his job is providing professional services. Personal liability insurance is not very common in Malaysia, but very widely used in western countries where personal litigation happens very frequently.

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INVESTMENT STRUCTURE FOR RETIREMENT (Cont’d)

Investment Risk

The funding for the retirement plan needs to be managed properly, and preferably, professionally. An investment strategy needs to be regularly reviewed and monitored to ensure returns meet the objectives. In most cases, investments made for the purpose of retirement have the following characteristics:
Longer term, some can be longer than 30 years, depending on the client’s age at the commencement of the retirement plan.
More conservative in terms of strategy; the aggressiveness of the investment depends on the risk profile and life cycle of the client. E.g. EPF.
Having tax-advantage e.g. EPF and/or EPF linked scheme.

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INVESTMENT STRUCTURE FOR RETIREMENT (Cont’d)

Islamic View on Risk Management

Islam teaches its adherents to mitigate risks
Islam views strongly that risks must be shared and not transferred

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INVESTMENT STRUCTURE FOR RETIREMENT (Cont’d)

Portfolio Theory Applied to Retirement Planning

Investment in retirement planning requires a process and portfolio theory is one of them. Diversification has always been a key strategy in minimizing the risks of investment as the fund is spread over a broad area of investment classes. Taking this to a more advanced level, the inter-relationships among investment classes or securities within a portfolio are considered as essential as the risk/return characteristics of the individual class or securities. This is redefined in modern portfolio theory.

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INVESTMENT STRUCTURE FOR RETIREMENT (Cont’d)

Modern Portfolio Theory
Capital Asset Pricing Model
Diversification
Taxation: There are some tax advantages for the following:

Equities
Property
Unit Trusts
Cash and Fixed Deposits
Life insurance and takaful products

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INVESTMENT STRUCTURE FOR RETIREMENT (Cont’d)

Asset Allocation
Property as an asset class

Characteristics

Types of returns
Level of returns
Leveraging tool

Permissible Islamic Mortgage

Ijara
Musharaka
Musharaka mutana kisah
BBA

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RETIREMENT SCHEME

Types of retirement plans

Pension schemes: A pension is a regular payment, made by the state or a former employer to a person who no longer holds office due to retirement or disability. The scheme is either voluntary or contractual. The receiver of the pension payment could either be the retiree, the widowed spouse or dependant child or other dependants of the pensioner. The stream of payments could be made by the employer or by the successor of the employer, or by the trustee of a provident fund or by arrangement by the insurance companies. In Malaysia, pensions are paid to ex-government servants who elected for this scheme.

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RETIREMENT SCHEME (Cont’d)

Pension scheme may be differentiated by the concept used to provide a retirement benefit, namely the Defined-Contribution Pension Scheme and the Defined Benefit Pension Scheme.

(a) Defined-Contribution Pension Scheme: In this scheme, both the employer and the employees contributed a defined amount of contributions to the funds. This method is sometimes referred to as the “money purchased pension scheme” because the participant’s in the account is traditionally employed to purchase an annuity from an insurer to provide pension payment during the retirement.

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RETIREMENT SCHEME (Cont’d)

Basic feature of Defined-Contribution Pension Scheme are as summarized below:-

The contribution is either defined as percentage e.g. 5% of the salary or on a fixed lump sum. The benefits could not be determined as the contributions and the earnings fluctuate from the time of inception until pension is drawn.
Often, the contribution is made by both parties, i.e. the employer and the employees. Each will contribute a pre-determined portion.
The risk of inflation, investment performance of the funds and the adequacy of income at retirement is wholly borne by the employee.
This method does not require actuary hence it is cost effective for the employee.
The administration method is simple and can be easily communicated.
If stipulated in the service agreement or allowed by law, the fund is portable or employee can continue with the same scheme with the new employer when he switches jobs.

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RETIREMENT SCHEME (Cont’d)

Defined Benefit Pension Scheme

The salient feature of this scheme is that the pension benefit is pre-determined at the inception, taking into consideration the post retirement standard of living of the retiree. Due to this reason, this type of scheme is considered more desirable by employees. This however requires more cumbersome and administration work on the part of the employers. define benefit plan is tax deductible

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RETIREMENT SCHEME (Cont’d)

Common attributes of the Defined Benefit Pension Scheme are:-

More responsibilities in terms of designing and administering of the scheme must be considered by the employers since the business must take into consideration the pre-retirement inflationary trend and adequacy of pension income to be paid to employees on retirement.
Since the benefit has been pre-determined, the employer assumes the investment risk to ensure that the fund is adequate at all time to pay the retirement benefit of the employees.
This scheme allows the employer to take into consideration the past service contributions of the employees in terms of time and productivity. This is one of the important aspects of this scheme.
Cost of administration of the fund can increase as constant computation and adjustment of the funds are to be made and the service of the actuary is also required.

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RETIREMENT SCHEME (Cont’d)

Funds need to be put aside in advance to make payment of the pension benefits. In the case of defined benefit pension-scheme, the cost of providing the benefits must be determined in advance. To determine the contribution, the actuary will need to consider the following factors:-

The retirement age of the participants, which is currently set at 55;
The projected mortality rate of the participants;
The present monthly salary level of the participants;
The projected salary growth of the participants in the future;
The forecasted number of participants who will demise or leave the scheme before receiving the benefits;
The returns of the funds.

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RETIREMENT SCHEME (Cont’d)

Under the defined-benefit pension scheme, it is assumed that the pension cost is equal to the benefits payout, plus the cost of administration, less the earnings (which include the capital gain or losses) of the funds. This however does not reflect the real cost to the employer as other cost which is difficult to quantify (such as enhanced employees’ morale, decreased employees turnover etc.) should be factored in. However, this is impractical, thus the net financial allocation ordinarily is acceptable to portray the cost of the scheme.

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RETIREMENT SCHEME (Cont’d)

Product and Service Support for Pension Schemes
In general, pension schemes can be divided into three types, namely:
Completely insured scheme;
Non-insured scheme; and
Split-funded scheme.

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RETIREMENT SCHEME (Cont’d)

Under the insured scheme, the life insurers will insure the scheme by using several of its suited products such as annuity plan, endowment or investment-link plan. Since the main objective of the pension scheme is to provide a regular income for retiree, an annuity plan is best suited for the purpose. An investment-link or an endowment plan can provide a lump sum at retirement of the participant and can be used to purchase an annuity. In Malaysia, the annuity payments made by either Takaful or from life insurer are non-taxable to the retirees.

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RETIREMENT SCHEME (Cont’d)

Non-Insured schemes are relatively uncommon in Malaysia. Such schemes are usually adopted by some trust corporations that are set up by the banks to meet their business needs. Under the non-insured defined benefit scheme, the estimated contributions to be made to the trust corporation are made by the actuary. The trust corporation will manage the investment of the funds deposited and when an employee retires, the trust corporation will make monthly or lump sum payment to the retiree on the instruction of the employer. In this case, the employer is considered self-insurer against all risk such as investment, mortality and other expenses. This type of scheme is not suitable for small businesses

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RETIREMENT SCHEME (Cont’d)

A Split-funding contract utilizes two or more types of contracts combined to provide the benefit payments to the participant. This type of funding is adopted in some advanced countries, where a bank and/or life insurer is used. The complexity of the arrangement requires the expertise of high order which is quite scarce in this part and as such it is uncommonly used in local companies.

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RETIREMENT SCHEME (Cont’d)

Profit Sharing Schemes

This is a type of defined-contribution benefit scheme which does not provide a monthly pension payment. This is because when the scheme was originally introduced, it was intended for the employees to share the profits of the company with the objective of increasing productivity. These schemes were later adapted to provide retirement benefits in order to avoid cash flow problems associated with other retirement schemes mandated to provide regular contribution by the employer.
The basic feature of the scheme is advantageous to the employers for reasons stated below:-

Flexibility – the scheme provides flexibility to the employer to choose whether or not to make contributions in certain years.
As a motivational component – this scheme can be designed to mark the contribution of the employer whereby if the target is achieved; the contribution by the employer to the fund is triggered.

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RETIREMENT SCHEME (Cont’d)

Since there are no defined contributions on the part of the employer, the retirement payment to the retiree in not guaranteed. As such, the scheme is not designed to the advantages of the employees.

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RETIREMENT SCHEME (Cont’d)

Share Option Schemes

Share options are offered to employees to purchase the company’s share at a certain price that has to be exercised before a particular future date. If the taken up price is lower than the market price, the employee can make a profit by selling the shares. In Malaysia, the gain is taxable in the hand of the employee as it is deemed capital asset.

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RETIREMENT SCHEME (Cont’d)

Allotment of Shares to Employees

A company may opt to provide a share allotment to its employees as part of its compensation program to retain productive workers. This kind of compensation does not have favorable tax treatment to the employers as this is not a tax-deductible expenditure to the company – as it is deemed that no expenditure is incurred in the transfer of ‘paper shares’ to the employees. However, the benefit is not taxable in the hand of the (golden parachute)

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RETIREMENT SCHEME (Cont’d)

Special Gratuities Schemes

Gratuities are payments and rewards for the services rendered to employees when they retire from active work or no longer able to work due to illness or disability. In the case where the employee is deceased, the gratuity payment will be made to their beneficiaries.

A gratuity would be exempted from tax if it is on retirement from an employment and the employee has served the company for more than 10 years and when retirement is due to illness.

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RETIREMENT SCHEME (Cont’d)

Benefit Design

The design of a retirement benefit will depend on the needs and the circumstances of the employers in mind. Some are designed to meet full retirement needs whereas some are designed to meet partial needs. The defined-contribution and defined-benefits are designed to meet specific needs such as a pension scheme. Some schemes have smaller retirement benefits but take bigger consideration in compensating and rewarding the employee as part of the retention scheme or motivating the employees towards achieving the company’s profit target.

In the Islamic context, the setting up of a pension plan by the employer to fulfill the needs of the employee during retirement is extremely encouraged as this forms part of the social security system.

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RETIREMENT SCHEME (Cont’d)

Security of Fund

For a retirement plan to succeed, there must always be accomplished funding. Of course, any funding that involves investment is exposed to risks, such as market risks and specific risks.

Market risks can be mitigated by using modern portfolio theory where diversification and asset allocation are crucial to ensure returns optimization. Hence, the common shift is from an aggressive portfolio at a younger age to that of a more conservative nature.

Specific risks can be mitigated by careful selection of investment tools; hence the expertise of the professional fund managers or asset managers will come to play.

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�PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES�

In Malaysia the most notable public scheme is the Employees Provident Fund (EPF) where defined contributions are made by both employee and employer under statute requirements. Other smaller retirement schemes or in-house schemes exist sporadically for certain sectors of the population or organizations; annuities are being introduced by life insurers. There is potential scope for tremendous growth in products and product providers specifically for retirement.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

The Employees’ Provident Fund was introduced by the Government on 1 October 1951 under the Employees Provident Fund Ordinance.
It was meant to provide better social security services by the government.
Initially, the scheme focused almost exclusively on old age welfare issues for the low income salary earners. Subsequently, the Employees Provident Fund Act was introduced in 1991 to provide a broader scope of the original scheme.
Presently, the EPF is the nation main social security program running a provident fund scheme for its members who include the private sector and the non-pensionable public sector employees.
EPF is considered a defined contribution scheme as the amount of contribution is defined as percentage of the earnings or a fixed sum. It is made compulsory for all employers to contribute to this scheme and failure to comply will this ruling will result with the company being charged in court.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Both the employees and employers have to contribute a specified amount by law. The contribution cannot be less than the stipulated but can be more.
Since 1994, the fund is divided into three and later reverted into two accounts

A/C	PURPOSE	% OF CONTRIBUTION
A/C I	For retirement purposes at age 55	70
A/C II	For housing, education and withdrawal at age of 50. Withdrawal for housing can be made every 3 years	30

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Retirement Plans in the United States
In the United States of America, most private-sector retirement vehicles are Individual Retirement Arrangements (IRAs), defined benefit (DB) plans or defined contribution (DC) plans. The setting up of IRA funds can be done by either individual who wish to set up their IRA funds or by assistance from the employers. With an IRA, the amount that an individual receives at retirement depends on the funding of the IRA and the earnings (or income) on those funds.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Defined contribution plans are employer-established plans that do not promise a specific amount of benefit at retirement. Instead, employees or their employer (or both) contribute to employees’ individual accounts under the plan, sometimes at a set rate (such as 5 percent of salary annually). At retirement, an employee receives the accumulated contributions plus earnings (or minus losses) on such invested contributions.

Defined benefit plans are qualified employer-sponsored retirement plans which provides a fixed and pre-established benefit at retirement, for example at $1200 a month at retirement. Like other qualified plans, and they offer tax incentives both by employers and to participating employees.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Small businesses may choose to offer Internal Revenue Services (IRAs), DC plans or DB plans. Many financial institutions and pension practitioners make available one or more of these retirement plans that have been pre-approved by the IRS. Some employers offer hybrid plans. Hybrid plans include defined benefit plans that have many characteristics of defined contribution plans. An example of hybrid plan is the Cash Balance Plan.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Payroll Deduction IRA Plan-employees only contribution.

Employees can contribute to an IRA through payroll deductions although the employer does not want to adopt a retirement plan. This provides a simple and direct way for eligible employees to save. The decision to contribute, and the quantum to contribute to the IRA (up to $4,000 for 2005 through 2007, increasing thereafter) is always made by the employee. This plan is also eligible for a single person active in an employer- sponsored retirement plan who has average gross earnings below USD41k (1999).
In a traditional IRA, the contributions may be tax deductible on the federal income tax return. This is important because tax-deductible (pretax) contributions lower the taxable income for the year. However, it is taxable upon withdrawal. However, even after paying taxes on withdrawals, there is still a substantial amount of savings compared to a conventional savings program.

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Advantages and Disadvantages of Payroll Deduction IRA

Easy to set up and operate
Little administrative cost or requirements
Employers may received little credit for this service from employees
No deductions for the business
Employees may or may not be able to deduct their contributions
Participants loan not permitted
In service withdrawals allowed subject to income tax and additional tax of 10% if under age 59.5.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Simplified Employee Pensions (SEP) Plan

A SEP allows employers to set up a type of IRA for themselves and each of their employees. Although the employer does not have to make contributions every year, they must contribute a uniform percentage of pay for each employee. For the year 2005, employer contributions are limited to the lesser of 25 percent of pay or $42,000. Most employers, including those who are self-employed, can establish a SEP. SEP have low start-up and operating costs. The employer can decide how much to put into a SEP each year since this plan offers some flexibility when business conditions vary.

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Advantages and disadvantages of SEP plan

Contributions are tax deductible and business pays no taxes on the earnings of the investment
Locked into making contributions every year
No filing of documents with government
Contributors could be sole proprietor, partnership, corporations
Eligible for tax credit of $500 per year for each of the first 3 years for the cost of starting the plan
Administrative cost are low

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Defined Contribution Plans

a) 401K Retirement Plans

The 401(k) plan has become a widely accepted retirement savings vehicle for small businesses in the US. It is estimated 42 million American workers participate in 401(k) that have total assets of about $1.9 trillion. A 401(k) is a type of retirement plan which allows the employee to save and invest for their own retirement. It is a special type of account funded through pre-tax payroll deductions. Under this plan, the employee will authorize the employer to deduct a certain portion of their salary before income taxes are taken out or as deferred payment on salary. The money will then be invested in the 401K Plan. These deferrals are accounted separately for each employee.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Most 401(k) plans provide a range of investment options. These options may include but not limited to the following:

Stock funds
Bond funds
Balanced funds
International funds
Company stock

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

The contributor can decide how their contributions are distributed among the plan's offerings. When deciding how to allocate your contribution, issues to consider include:

The long-term financial objectives.
Tolerance for risk.
How close to retirement age.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Generally, the deferrals (plus earnings) are not taxed by the federal government or by most state governments until distributed. A 401(k) plan can vary significantly in their complexity. However, many financial institutions and other organizations offer prototype 401(k) plans which can greatly lessen the administrative burden on individual employers of establishing and maintaining such a plan.
E.g Starbucks “total pay package” the company will match a percentage of the first 4% of pay the employee contributes to their 401k retirement plan. <36 months 25% match; 36 to 60 months a 50% match; 60 to 120 months a 75% ; 120 or more months receive a 150% match. Employee with 10 years earning $100,000 contribute $4000 will get $6000 into the 401K

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Benefits of 401K

Tax advantage
Employer match programs
Investment customization and flexibility
Portability
Loans and hardship withdrawals

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Safe Harbor 401(k) Plans

A safe harbor 401(k) plan is intended to encourage plan participation among rank and file employees and to ease administrative burden by eliminating non discriminating annual testing usually applied under a traditional 401(k) plan. This plan is ideal for businesses with high salaried employees whose contributions would be limited in a traditional 401(k) plan. A safe harbor 401(k) allows employees to contribute a percentage of their salary each paycheck and requires employer contributions. In a safe harbor 401(k) plan, the mandatory employer contribution is always 100 percent vested.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

The Employee Retirement Income Security Act of 1974 (ERISA), which was signed by President Ford on September 2, 1974, adopted a sweeping overhaul of the existing employee pension and welfare benefit rules (both non-tax related and tax related), encouraging a three-leg approach to retirement funding, namely:

Social security
A worker’s own savings
A company pension plan paid out of funds set aside by the company for a defined pension plan for their employees

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Profit-Sharing Plans

Contributions to a profit-sharing plan are at the discretionary of the employers. There is often no set amount of what they need to contribute each year and if they choose to, the amount will differ according to their set plans.

The Fallacy of ERISA

The ERISA below illustrates the market risks related to changes in government legislation. In 1974, a law was passed by the United States Congress with the intention of encouraging individuals to save for their own retirement.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Prior to the ERISA, the popular feature of cash or deferred arrangements (CODAs) under Section 401(k) of the Inland Revenue Code in profit sharing plans was in place in the early 1950’s – under this arrangement, an employee could elect to receive a portion of employer profit-sharing contribution in cash or defer it under a profit-sharing plan.
In 1972, the Inland Revenue issued proposed regulations related to taxation of salary reduction contributions; this created issues and uncertainties with respect to CODAs. Then in 1974, ERISA changed the tax status of plans with CODA features.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

The ERISA was passed as a benefit to employees, but in many ways it was a benefit to the employer, as corporation tax benefits were attached to company sponsored plans. As described above (section 8.4.1), the government’s direct benefit pension plan had become a direct contribution pension plan. The expense of retirement was then transferred from the employer to the employee.
Under the arrangement, the employees had the option to contribute to the plan or not. The employer just had to match (but actually pay less with the company benefit).

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Pension Systems in the Middle East and North Africa (MENA)

Pension systems in the Middle East and North African countries today are at a crossroads. They all have earnings-related pension schemes, in essence financed on a pay-as-you-earn basis, which were formed in the late 1960s and early 1970s.

Basically, pension funds today favor middle and high income workers at the expense of low income wage earners. These schemes cover, on average 30 percent of the labour force. Despite these relatively modest coverage levels and the fact that only 5-10% of the elderly actually receive a pension, expenditures are already in the range of 1-3% of the gross domestic product (GDP), which is above expectations, given international patterns and current demographics.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

There have been various proposals written for reforms, the following being some of the reasons for change:

Administrations of pensions are fragmented, often with two or more schemes for different groups of workers. This is unnecessarily costly, and leads to poor mobility of labor across sectors.
Much of the workforce remains uncovered by a formal pension scheme.
Governance and administration of pension schemes are weak. In particular, pension reserves are not managed in the best interest of the members.

On average, the mandates of pension systems in terms of income replacement are more onerous in the Middle East and North Africa than in other regions. The replacement rate (the pension divided by the last salary) is used to measure the share of total gross income that is replaced or preserved at retirement.

Benefit formulas and eligibility conditions damage incentives.
Redistribution with pension systems is nontransparent and can be regressive.
Pension systems are financially unsustainable as a result not of future aging of the population but of poor system design

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Barriers to Pension system-MENA

Lack of education awareness among the population
Financial barriers

Lack of mortality tables and annuity products
Non-existent of tax incentives
Poor supervisory oversight
Lack of regulatory reforms in terms of funding and investment rules, transparency and information disclosure and proper governance rules
Generous social security arrangements means little room for private pensions to develop.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Australia’s Superannuation Plans

The Australian Superannuation program is a defined contribution plan, a private pension plan, albeit mandated by the federal government. Superannuation is a form of savings where money is set aside by the employee and the employer and invested for retirement of the employees. Contributions are made by the employer to a fund the ownership of which is vested in the individual worker. When it was introduced in 1992 the contribution rate was 3% with provision for it to increase by increments to the present 9%. Payouts to workers upon retirement are dependent upon the accumulated value of their individual funds.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

The retirement savings grow because money is paid in regularly and invested at a concessional rate of tax. Tax concessions and other government benefits currently make superannuation one of the best long-term investments.
Due to recent changes in the law, from 1 July 2005 certain employees are able to choose which fund their employer's future superannuation guarantee contributions are paid into. This is known as choice of superannuation fund. If the employee does not specify their choice, the decision will be made by the employer.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Employers must pay compulsory superannuation contributions into a complying superannuation fund or retirement savings account for their eligible employees. This is known as the superannuation guarantee. Failure to comply will make them liable for the superannuation guarantee charge.
The key features of superannuation are:

your employer must contribute 9% of your earnings base to your fund
money from your superannuation account can usually be taken out only at retirement, and
it is generally taxed at a lower rate compared to other forms of investment.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

There are four basic types of superannuation fund:

corporate funds, which are open to people working for a particular employer or corporation which also includes public sector funds;
industry funds, which are open to people in a particular industry or under a particular industrial award;
retail funds run by financial institutions, which are open to the public, and
self managed superannuation funds, which are open for up to four people.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Superannuation funds are set up under a trust deed. Trustees run the fund and, by law, they must act honestly and prudently, and make decisions in the best interests of all members.
A retirement savings account is a superannuation account offered by a bank, building society, credit union or a life insurance company. Retirement savings accounts differ from other superannuation funds because they don’t have a trust structure and are run like a bank account.
The Superannuation funds are regulated by three government agencies namely:

the Australian Securities and Investments
the Australian Prudential Regulation Authority
the Tax Office - regulates self managed funds, employer contributions (the superannuation guarantee), co-contributions and superannuation tax rules.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

Canada’s RRSP

A Registered Retirement Savings Plan (RRSP) is a personal savings plan registered and approved with the Canadian federal government. The program is designed to encourage Canadians to save for their retirement by providing powerful tax reduction options. An RRSP is an investment portfolio designated for retirement savings. It can contain a variety of investments such as RRSP savings deposits, treasury bills, guaranteed investment certificates (GICs), mutual funds, bonds, and even equities.

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PROVIDENT FUND AND OTHER RETIREMENT FUND SCHEMES (Cont’d)

The tax breaks come in two forms. The first is that when the RRSP is set up, the financial contributions make are deductible from your taxable income. The second tax advantage resides in the sheltering of the income and capital gains that are generated by the investments in the RRSP. What it simply means is that the money is allowed to grow tax free unlike other investments like GICs, stocks and mutual funds. But all investments within an RRSP are effectively "sheltered" from tax and allowed to compound.
The income earned in the RRSP is not taxed until it is withdrawn. By the time the money is withdrawn from the funds at retirement, the contributor will probably be in a lower tax bracket than during his earning years. Funds withdrawn at that time will benefit from this lower tax rate. RRSPs can be for an individual only or placed in the name of a spouse.

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STREAMING RETIREMENT INCOME

Definition of Income Stream

An “income stream” is simply a term used to cover any range of products that bring forth a steady stream of income. Issues of control and management will be of most concern to the retiree.

Vehicles Providing Income Streams

Pension

Pension schemes have been explained in detail in subsection 8.4.1. In Malaysia, it is common knowledge that government servants receive a monthly pension after retirement, calculated as a percentage of the last drawn salary. In the event of death of the retiree, the pension continues to be paid to the deceased’s spouse.

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STREAMING RETIREMENT INCOME (Cont’d)

The private sector, on the other hand, pays a “pension” where there is a superannuation scheme.
Under the Malaysian Income Tax Act 1967, pensions received by an individual are exempt under the following conditions:

He retires at the age of 55/60 or at the compulsory age of retirement under any written law; or
He retires due to ill health

For an employee in the public sector who elects for optional retirement, his pension will be taxed until he attains the age of 55 or the compulsory age of retirement under any written law. Where an individual receives more than one pension, the exemption is restricted to the highest pension received by him.

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STREAMING RETIREMENT INCOME (Cont’d)

Other sources of income streams

Employees Provident Fund (EPF)
Takaful or Life Assurance
Health Insurance
Annuities
Fixed Deposit Income
Income from Unit Trusts/Mutual Funds
Income from shares
Income from properties

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DISCOUNTED CASH FLOW CALCULATIONS Pre-retirement

It should be noted that the calculations for the pension funds or future income have to be calculated based on discounted cash flows to reflect the changes in money value.
Ali’s retirement plan is to have a lump sum of $2million. He is currently 36 years old and would like to retire at age 55. Assuming the pre-retirement rate of return is 8%. Calculate:

a) the pre-retirement funding income stream needed at the beginning of each period, if the income stream are flat annually; and
b) the first income stream if such income stream increase by 10% per annum.

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DISCOUNTED CASH FLOW CALCULATIONS Pre-retirement

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DISCOUNTED CASH FLOW CALCULATIONS Pre-retirement

2 steps
B 1)

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FV = PV (1 + r)

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DISCOUNTED CASH FLOW CALCULATIONS Pre-retirement

B2) calculate growth adjusted discount rate, given investment rate is 8% and annual contribution growing at 10%
Adjusted rate = r-g/1+g =.08-.10/1.10 =-.0181818

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Post retirement – inflation factor

At age 36, Amir wants to retires with an inflation adjusted retirement income of $5,000 per month. Post retirement rate of investment is 6% and post retirement inflation rate is 4%. Determine the lump sum required at the point of retirement, if the principal is:-
A. intact
B. liquidated over 30 years

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b. Principal liquidation method

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Review Questions

1.Discuss the different kinds of Islamic financing instruments that result in incoming streaming

2. Explain the concept of Retirement from Islamic perspective

3. a.Explain the replacement ratio method and expense method and its advantages and disadvantages.

b. Explain the capital retention method and capital liquidation method.