Thursday, July 16, 2009

Impact of the Financial Crisis on Retirement Security in U.S: A Lesson to Learn

By : Ezry Fahmy Bin Eddy Yusof


There is no doubt the United States pensions industry has been badly bruised by the global financial crisis. These are tough times in the United States, but if the current crisis continues to spread, it will surely deteriorate the employee’s retirement income. Certainly the road ahead isn’t easy, but it’s not an impossible one, there are still many possible avenues for individuals to diversify their portfolios to make sure they could achieve their retirement goals. Therefore this paper will first explain the connection that relates subprime mortgage crisis towards the retirement plans in the United States. Furthermore explain how the financial crisis affecting one of the popular retirement plans in United States, the 401(k) plan. Lastly, the author believes that some of the Islamic finance instruments could help the employees in achieving their retirement goals as well as helping the employees to exercising the fundamental principles in investment.

1.0 Introduction

A crisis that affects the entire financial system began in the mortgage financing sector of the financial system of the United States and spread rapidly to the global financial system. As mentioned by Abbas (2009), since U.S financial system is the epicentre of the crisis, therefore the analysis of recent crises has to start with the U.S. system’s financial structure and the conditions that led to the crisis. According to Baker (2008) the central elements that we call as the housing bubble lead the house prices peaked but began to turn down in the middle of 2006, this result a rapid rises in the default rates especially in the subprime market.

2.0 The world financial crisis

It is a worldwide financial fiasco involving the terms such as sub-prime mortgages, collateralized debt obligations (CDO), frozen credit markets and credit default swaps. First and foremost, it relates with two groups mainly the home owners and the investors; the home owners represent their mortgages while the investors represent their money. These mortgages represent houses and this money represents large institutions like pension funds, insurance companies, sovereign funds, mutual funds and etcetera. The financial system brought these people together, in addition with the banks and broker who commonly known as Wall Streets. Directly or indirectly, these banks on Wall Street are closely connected to these houses on Main Street (Baker, 2008).

2.1 Sub-prime mortgages

It happens when the home owners default on their mortgage, the lender gets the house and houses are always increasing in value. Since they are covered in the home owners default, lenders can start adding risk to new mortgages not requiring down payments, no proof of income, no documents at all and that is exactly what they did. So instead of lending to responsible home owners called prime mortgages, the lenders approved applications even the applicants can be considered as among those who are not creditworthiness (Baker, 2008). These are the turning point when it get involves the sub-prime mortgages.

Thus the sub-prime mortgages that are comprised of defaulters are like bombs that are waiting time to explode. The subprime mortgage crisis in the grip of which the U.S finds itself at present is also a reflection of excessive lending. When the mortgage broker connects the family with the lender and the mortgage, this way the family could get the house easier as well as the mortgage broker able to get his commission. The lender sells the mortgage to the investment banker who turns it into a CDO and sells slices to the investors and others. This way works out nicely because everyone selling off their risk to others and making millions.

Therefore, the home owners default on their mortgage which at this moment is owned by the banker. This means forecloses on one of his monthly payment turns into a house. It’s been reported that according to the Mortgage Bankers Association, roughly 4.2 million mortgages were overdue or in foreclosure at the end of 2007 (Chapra, 2008). Now when there are so many houses for sale in the market, creating more supply than there is demand and housing prices aren’t rising anymore, in fact, they plummet. This creates an interesting problem to the home owners who are still paying for their mortgages, since most of the house in their neighborhood up for sale, their house started to devalue. Home owners now realizes that they have to pay higher mortgage while their houses are worth lower than the actual price they are paying.

The home owners walk away or so called default, and default rates sweep the country and prices plummet. Now the investment bankers like Merrill Lynch, Lehman Brother Inc. are basically holding a box full of worthless houses. The investment banker tried to sell the CDO to the investors but they refuse to, because they already bought thousands of these CDO. On the other hand, the lender also tried to sell their mortgages but the bankers won’t buy it, thus the broker is out of work. These lead the whole financial system went frozen.

2.2 Other main causes

Besides number of causes that lead to the crisis, Chapra (2008) quoted the BIS in its 78th Annual Report by saying that the fundamental cause of today’s problems in the global economy is excessive and imprudent credit growth over a long period. The worrisome that lead to the crisis is already detected earlier because of the imbalances in the U.S economy when it’s public-sector budgetary deficits and the private-sector saving deficiency (Chapra, 2008).

Furthermore, some hold a view that human characteristic that was most responsible for the credit crunch is human greed. This opinion is not only according to The Archbishop of Canterbury, Dr Rowan Williams but also agreed by most of the Muslim scholars like Nejatullah Siddiqi (2006), Umer Chapra (2009), Hussein Shehatah (2009) and so forth. Human greed come into picture when the absence of ethics and morality lead the investors, bankers, and people in the market becoming greed to maximize profit, wealth and consumption by any means in keeping with the mores of the prevailing secular and materialist culture. Hence Muslim leaders from around the world are calling for world leaders to work together to prevent the burden of the financial crisis from falling on “the weak and the poor.”

3.0 Retirement plans of the individuals available in U.S

For many individuals, social security is the primary sources of retirement income. Keown (1998) states that 95 percent of all Americans are covered by Social Security and the size of the social security benefits is differ between one to another depends on the number of years earning, the average level of earning and an adjustment for inflation. Pension funds in the private and the government sectors collect pension contribution and invest them according to goals of the employees for their funds (Encyclopaedia of Business and Finance, 2007). U.S retirement plans for an individual can be classified into several categories which are defined benefit plans (employer funded pensions) and defined contribution plans (employer sponsored retirement plans) to those who work in private or public sector. There are also retirement plans for the self-employed and small business employees.

3.1 Defined benefit plans

Under defined benefit plan, employees receive a promised payout at retirement. Generally these plans are non-contributory retirement plans where the employer provides all the funds and the employee need not contribute, while contributory retirement plans in which the employee with the help of the employer, provides the funds for the plan. The advantage that defined benefit plans offer is that the employer bears the investment risk associated with the plan, which means the retirees still promised the same amount regardless of what the stock and bond markets do (Keown, 1998; Kapoor, et al., 2007). However, besides this traditional defined benefit plans, many companies started to switched to cash-balance plans where employees are credited with a percentage of their pay, plus a predetermined rate of interest rate (Keown, 1998).

3.2 Defined contribution plans

The other pensions plan namely defined contribution plan, this kind of pension plan bring either the employer alone or the employees and the employer together contribute directly to an individual account set aside specifically to the employees (Keown, 1998). This plans also sometimes called individual account plans. Generally defined contributions plans take one of the several basic forms, including profit-sharing plans, money purchase plans, thrift and saving plans, or employee stock ownership, and salary reduction or 401(k) plans (Keown, 1998; Kapoor et al., 2007).

In this plans, what the employees get is depends on how well the retirement account performs. Most of the defined contribution plans allowed the employees to choose how they would like the account to be invested. These kinds of plans involve no risk for the employer, thus employer pass the responsibility to the employees and don’t really care because their responsibility ends with their contribution.

3.3 Other retirement plans

In addition, the retirement plans for the self-employed and small business employees consists of three basic types of plans which are simplified employee pension plan (SEP-IRA), savings incentive match plan for employees (SIMPLE plan) and self-employed retirement plan (Keogh plan). Besides that U.S also provides individual retirement account (IRA) as another method to fund retirement, there are three types of IRAs which are traditional IRAs, Roth IRAs, and Cloverdell Education Savings Accounts (Keown, 1998).

However, despite of many retirement plans in the U.S, Weller (2009) statement are parallel with research done by Retirement Confidence Survey in answering how much have American workers saved for retirement? The result shown that many Americans have little money put away in savings and investments, “53 percent report that the total value of their household’s savings and investments, excluding the value of their primary home and any defined benefit plans, is less than $25,000. Twenty percent say they have less than $1,000 in savings”. Thus older workers tend to have more saved than younger workers, but overall savings levels tend to be modest.

4.0 Implication of world financial crisis on the retirement plans of the individuals

Poerio and Chapman (2009) reported that U.S pension plans have lost as much as 2 trillion in the current volatile market. Falling stock prices really affected the pension funds since majority of the pension funds are held in form of equities (Weller, 2008; Kansas, 2009; Mundell, 2009; Poerio and Chapman, 2009).

It is believed by Weller (2008) that the pension funds of Americans already bad before the crisis hit, he says that “retirement security has been growing concern for Americans for many years due to limited retirement plan coverage, little retirement wealth, and increasing risk exposure of the individual” (p.2). This means too few people in the Americans people are covered by a retirement savings plan at work. The spiral effect of the crisis not only impact the houses prices, but also affecting the American pension’s fund. Weller (2008) also sees that most of the American treats their home as their primary source of household wealth. Thus when the crisis hit, the declines in house price quickly decimate their wealth.

According to Munnel, Aubry, and Muldoon (2008), the financial crisis crystallized the differences between the traditional defined benefit plans and the defined contribution plan such as the 401(k) retirement plan since the 401(k) is where the individuals bear the risk, thus when the stock market collapse, they take immediate hit towards their retirement plan. Those who in this plans am about to retire less, or had to be re-employed after their retirement. Kansas (2009) feels the underscoring the anxieties that faced by the employees that about to retire and the younger employee who wonder whether is it still worthwhile to invest in stocks, the 401 (k) system puts too much burden to the people that it was suppose to help.

Amid the crisis, the public is worried about their retirement security in terms of their ability to afford a comfortable retirement. The April 2008 Gallop poll also concludes that the increasing of worries among the Americans in several matters such as will they have enough money for their retirement, will they able to pay their medical cost if serious illness or accident happens, and will they able to maintain their current standard living. This is why the public viewed retirement as a more important issue for Congress rather than the mortgage crisis, taxes or even education. The rising cost of necessities explains why both the retirement age and younger concerned about their retirement security (Weller, 2009). If this continues, surely people will tap their retirement plan even before the recession is over.

4.1 The fragility of the 401(k) plans

A 401(k) plan is a popular defined contribution plan in the U.S and can be defined as a tax-deferred retirement savings plan in which employees of private corporations may contribute a portion of their wages up to a maximum amount set by law. Moreover, employers may contribute a full or partially matching amount, and may limit the proportion of the annual salary contributed (Keown, 1998).

The fragility of the 401(k) plans, as the sole supplement to social security has been highlighted even before the financial crisis. Why the researchers concentrate into this plan mainly because most employees (the Americans) today have 401(k) as their primary or only plan (Munnel, 2009). In some cases, the companies force the employees to invest their 401(k) contributions to the employer’s stock in order for the employee to participate in an employer’s retirement plan (Madura, 2006). This action is not only unethical but also leaves the employee’s present and future wealth expose if the firm’s financial condition deteriorates.

The crisis dropped the 401(k) value up to 30 percent. This result due to people that losing their jobs and lead to a fewer contribution and more hardship withdrawals (Mundell, 2009). As mentioned by U.S Bureau of Labour Statistic, about 3.6 million people losing their jobs during the financial crisis. People without jobs could not contribute to 401(k) plans, while those with jobs are turning their 401(k) plans for help.

Besides that, Mundell (2009), Kansas (2009), Sallisbry and Buser (2009) realizes that companies that under pressure are suspending their matching contributions. In addition, some companies that are eliminating or curtailing the employer match entirely in the 401(k) plans which are General Motors, Cushman & Wakefield, Eastman Kodak, Vail Resorts, Saks, Sears Holding, Motorola, UPS, Hewlett-Packard, and National Public Radio (Kansas, 2009).

4.2 The needs to reconstruct U.S retirement security

“Don’t invest in something you don’t know” said billionaire, Warren Edward Buffett (Bianco, 1999). These words of wisdom reflects the consequences of what happens towards recent 401(k) litigation when participants suing the plan fiduciaries on the grounds that the participants were not adequately warn of the risk of the investing in certain stocks, or the employer inadequately monitored the investment performance of the funds available for the investment (Poerio and Chapman, 2009).

Obviously, the recent financial crisis has accelerated a re-examination of U.S retirement income system. It is inconsistent policy approach to try to introduce beneficial features from traditional defined benefit into 401(k) plan, while at the same time pursuing the same approaches that are harmful to the same defined benefit plans that are used as model for retirement savings. What the congress should do is to consider both strengthening the existing defined benefits plans and also try to improve the existing 401(k) plan. This suggestion parallel with what stated by Weller (2009) where he thinks that the public policy should strengthen the existing defined benefit plans that already do a good job of offering retirement security to American families, and policymakers should adopt policies that will allows plans that lack of important criteria to incorporate features that will bring them to closer to the ideal retirement plans. He before that stated that an ideal retirement plans should covers all these criteria which are broad-based coverage, secure money for retirement, portability of benefits, shared financing, lifetime benefits, spousal and disability benefits, professional management of assets, and lastly low costs and fees (Weller, 2009). This may sound idealistic, but it is not possible to build such retirement plans. Mundell (2009) and Weller (2009) both agreed that shore up the retirement current retirement income system, besides avoiding the further reductions in a Social Security, it is in need of introducing a new tier of retirement income.

If the Congress and the administration did not take this matter seriously, they will most likely see how American’s workers’ retirement security continue worsen since it has been declining for many years. Therefore, it is a must to improve retirement security by building a better defined contribution plan and strengthening defined benefits plan. Policymakers should take a pragmatic approach by considering all efficient policy options to rise retirement saving among the Americans.

5.0 Other possible avenues to prevent the deterioration of the retirement income

The retirement planning is a requirement, it’s also reflects good wealth management that are encourage in Islam. There are many other possible avenues that individuals can involves in to avoid the deterioration of their retirement income, ponder the retirement in advance so that the retirees won't feel rushed into making last-minute decisions when it's time to quit.

5.1 Understanding the fundamental principles in investment

The most important fundamental principles that could guide an individual in investment are by understanding the concept of asset allocation, diversification, and rebalancing. Asset allocation involves dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash. The process of determining which mix of assets to hold in individuals portfolio is differ from one person to another, depend largely on one’s time horizon and ability to tolerate risk. On the other hand, the practice of spreading money among different investments to reduce risk is known as diversification, the investors may be able to limit their losses and reduce the fluctuations of investment returns without sacrificing too much potential gain. The last important fundamental principles that investor should know is rebalancing, rebalancing basically means to bring the entire portfolio back to the investor original asset allocation mix in order to meet the investment goals, through rebalancing the investor could manage the portfolio so that it does not overemphasize one or more asset categories, and the investor could have a return portfolio with a comfortable level of risk (Keown, 1998; Kapoor, et al., 2007).

These above mentioned knowledge in investment is essential especially in the time of financial crisis. Many Muslim economist and renowned scholars like Chapra (2009) believes that Islamic finance is the best alternative towards the current economic crisis. This is due to the framework of Islamic economics that encourage risk sharing along with the availability of credit for primarily the purchase of real goods and services and restrictions on the sale of debt, short sales, excessive uncertainty (gharar), and gambling (maysir) that surely could help to inject a greater discipline into the economic system. Thus, the year 2009 is a milestone for Islamic banking where it passed the test of the crisis and proved its resilience and choosing Islamic products or type of investment may be the right choice. Even the Vatican's official newspaper, L'Osservatore Romano reported that the basic rules of Islamic finance could relieve suffering markets and particularly international financial systems (World Bulletin, 2009).

Abide by the fundamental principles that already explained, to avoid the deterioration of the retirement income through the practice of assets allocation, diversification and rebalancing is a must in an individual’s investment portfolios, in order to meet the retirement investment goals. Among the other possible avenues that are available as alternatives that could be think of are several Islamic products such as Islamic bonds or also known as Sukuk, Islamic Real Estate Investment Trusts (Islamic REITs), investment-linked takaful, and gold investment,

5.1.1 Islamic Bonds (Sukuk)

Since there are many Islamic banks started growing in the U.S, Islamic products should be the best alternative for the investors especially if it is regards to long term investment. Among the best choices are Islamic bonds or so called Sukuk, it is now one of the world fastest growing capital market products today. As what reported by the Islamic Finance Information Service, the average growth rate stands at 40% with the total volume issued amounting to USD82 billion in 2007. Sukuk are trust certificates or participation securities that grant investors a share of the asset along with the cash flow and risks that commensurate from such ownership.

Dawood (2009) also believes that U.S will become a leading target for sukuk issuers, and as familiarity with the asset class increases, the investor base will broaden. Thus sukuk is a better portfolio to be included in since it is one way of a long term investment that can be exercised by the retirees to make sure the availability of extra income during retirement period.

5.1.2 Islamic Real Estate Investment Trusts (Islamic REITs)

Real estate investment trusts (REITs) are collective investment vehicles that are typically in the form of trust funds which pool money from investors to buy, manage and sell real estate. Returns in Islamic REITs are generated from rental income plus any capital appreciation that comes from holding the real estate assets over an investment period (Rosly, 2007). Unit holders will receive their returns in the form of dividends or distribution and capital gains for the holding period.

Islamic REITs extend the lives of portfolios based on equity-oriented strategies, but provide even greater benefits. Moreover, specific types of investment in real estate, either directly or in securitized fashion (a diversified real estate fund), could provide steady retirement income while not running afoul of Shariah law.

5.1.3 Investment-linked takaful

Takaful (Islamic insurance) is a concept whereby a group of participants mutually guarantee each other against loss or damage. Each participant fulfils his or her obligation by contributing a certain amount of donation or known as tabarru into a fund, which is managed by a third party which is the takaful operator (Rosly, 2007). Moreover, an investment-linked takaful is one kind of family takaful plan that combines investment and takaful cover. With the monthly contribution, it gives the contributor a takaful coverage, which includes death and disability benefits, and also an investment in a variety of Shariah approved investment funds of the contributor’s choice (Nurdianawati, 2009).

Some of the advantages of holding a family takaful policy are that the participants can select the maturity date, profit sharing is according to the agreed ratio, and the policy can be terminated at any time. There are also exists some flexibility to change the premium paid, the period and the number of instalments in one year, and there is additionally exemption from income tax (Billah, 2003). Therefore, this could help the retirees to have an extra income when it comes to maturity period as well as gives them medical assurance especially during after their retirement period

5.1.4 Gold investment

Gold is largely seen as a safe haven from the volatile markets threatening to wreak havoc almost every other investment instrument known to men. Gold has always been the best means of storing wealth. The consistently stable purchasing power of Gold creates a strong foundation to ensure protection from currency speculation and the instability of paper currencies. Sykora (2009) reported that a portfolio manager of Tocqueville Gold Fund, saying that when investors don’t feel they can safely place their money into financial assets, gold is usually come to the top of the list of investment. Gold’s ‘perfect storm’ rages on especially when there has been a tremendous increase in the desire to hold physical gold such as coins or bars (Sykora, 2009).

Among the methods that can be use to invest in gold are by investing in gold bullions or coins, investing directly in the stock of gold mining company, or even to gold-related funds where it is invest partly in gold and the rest in related instruments but it is very volatile. Besides that, if the investors don’t have storage space for physical gold, investing and trading on physical gold stored in a vault is an alternative where some banks provide a gold passbook accounts. Those who want even more diversification into gold companies, an exchange-traded fund (ETF) will provide the cheapest way to buy into the gold bullion market. Lastly, gold structured products are themselves in the form of forwards or gold linked bonds and structured notes (Ming, 2009).

6.0 Conclusion

In a nutshell, for many people, the ideal retirement destination is the ultimate goals. The goal should be to accumulate the highest value of investments by retirement age. People may just question how much it would be consider being enough at the age of retirement and the amount is differ from one person to the other. But due to the impact of the world financial crisis, most of the people that nearing their retirement period may need to be re-employed or are forced to rely on grown up children. Therefore, to ensure this is not happen, it is important to plan for the retirement if the retirees want to be independent in the golden years. The choices for investments that available in the market are so wide, with careful research; all of the planning will surely pay off.
*Download full project paper (included the references used) here.
Ibn Yusof
16 July 2009 / 23 Rejab 1430

1 comment:

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