Part 1: Introduction to Pensions
NOTE: This information should not be regarded as financial advice and is merely a learning and awareness initiative.
All eligible Muslim workers will be auto-enrolled into a pension scheme or opted out for whatever personal reason. Pensions are now inherent to employment and work life. However, many Muslims are unaware about pensions and Shariah compliance. To develop learning and understanding in this area, Amanah Finance Consultancy will be releasing the following articles over the coming weeks:
Part 1: Introduction to pensions
Part 2: What is a Shariah-compliant pension?
Part 3: Review of Shariah-compliant pensions for the UK workforce
The importance of having Shariah-compliant pensions cannot be overemphasised. Pensions are the income we will draw on upon retirement. In most cases, a pension is the income of one’s final years of life. No Muslim would want to live the last years on earth being nourished with unlawful income.
What is a pension?
Put simply, a pension is savings for you to use upon retirement. What happens between now and retirement with your savings is the key part. That is where it gets a little technical. A pension fund is the vehicle used in the interim.
A pension fund is an investment product which invests your salary, tax relief and any employer contributions into a portfolio of assets.
All eligible Muslim employees will be auto-enrolled into a pension. Automatic enrolment was phased in from 2012, starting with the largest UK employers. All eligible workers should have been automatically enrolled in their employer’s workplace pension scheme by 1 February 2018[i].
What are the types of pensions?
There are different types of categorisations for pensions. We will consider the most popular categorisation of pensions in terms of what determines the total value of your pension. There are two types of pensions in this regard: defined contribution and defined benefit.
A defined contribution pension is the most common type of pension. On retirement, the amount your defined contribution pension is worth depends on how much money you’ve contributed and the performance of your investments. Most modern workplace and personal pensions are defined contribution pensions. Other types of pensions such as AVCs (Additional Voluntary Contributions), SIPPs (Self-Invested Personal Pension) and SSAS (Small Self-Administered Scheme) are all types of defined contribution schemes.
Defined benefit pensions – also known as final salary schemes – promise to pay a retirement income based on a percentage of your salary. What you receive depends on how long you spent working for your employer, and how much you were earning at the time you gave up work. Outside of the public sector, this type of pensions is pretty rare nowadays[ii] .
One of the key differences between the two is that in a defined contribution scheme, the final value is based on the performance of the pension investment portfolio. Whereas in a defined benefit scheme, the final value is based on the final salary/career average and the length of employment as opposed to investment performance.
Different investment approaches and categorisations
There are thousands of different investment funds available to UK investors offering a wide range of different options, including[iii] :
- Asset type ( e.g. equity, fixed interest, property or cash funds)
- Investment in specific geographical areas (e.g. country or region-specific funds)
- Risk-adjusted funds where assets are chosen to suit a particular risk profile or investment style (e.g. cautious, balanced or aggressive funds)
- Combination funds which combine a number of the different sectors above (these include managed funds)
- Funds which alter their risk profile as you approach a target date (e.g. lifestyle funds)
The next article will be looking at what it takes for a pension to be Shariah-compliant.
[i] Pension Advisory Service https://www.pensionsadvisoryservice.org.uk/about-pensions/pensions-basics/automatic-enrolment
[ii] Pensionbee <https://www.pensionbee.com/pensions-explained/pension-basics/what-is-a-pension>
[iii] Pension Advisory Service https://www.pensionsadvisoryservice.org.uk/about-pensions/saving-into-a-pension/choosing-investment-funds