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The implication of world financial crisis on the retirement plans of the individuals and the possible avenues to prevent the deterioration of the retirement income June 25, 2010

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The implication of world financial crisis on the retirement plans of the individuals and the possible avenues to prevent the deterioration of the retirement income

rhesayogaswara@yahoo.com

Certified Islamic Finance Professional (CIFP) Candidate

INCEIF – Kuala Lumpur – Malaysia

Abstract

World financial crisis that happened many times, have been affected to the world. The recession was happening in many countries. The impact was not only to the country level, but also indidual level.

Therefore, with the purpose of financial stability in retirement, retirement planning, as part of wealth planning management is one of the best methods that individual can do to minimize risk from financial crises impact. Therefore, risk in individual level could be decreased.

One of the good impacts is the changes of purchasing power, which will be decreased. It means that the individual’s lifestyle is almost unchanged. For example eating frequently and nutrient-rich foods can be fulfilled.

At the end, the economic condition globally can avoid the recession. It is because of the stability in the macro and micro economic aspects.

1.0 Introduction

World financial crisis were associated with banking panics or recession that happened in many countries in the 19th and early 20th centuries.[1] Other situations in more specific conditions of financial crisis are stock market crashes, the bursting of financial bubbles, currency crisis, and sovereign defaults.

Banking panic is called systemic banking crisis. That situation was happened while bank were reluctant to lend because they worry that they have insufficient funds available, and it was widespread.

The bursting of financial bubbles is a crisis that happened while financial asset’s price exceeds the present value of future income. If there is a bubble, there is also a risk of a crash in asset prices. It happened while the market participants will go on buying only as long as they expect others to buy, and when many decide to sell the price will fall.

Currency crisis is a balance of payments crisis, which happened because of a speculative attack that forced the country to maintain a fixed exchange rate by devaluating its currency.

The last is recession, it is a negative GDP growth in the last two or more quarters. Sometimes, it is called economic stagnation, or depression, while happened in a long period of slow growth.

Many recessions have been caused by financial crisis. For example is the Great Depression, which was preceded in many countries by bank runs and stock market crashes. The sub prime mortgage crisis and the bursting of other real estate bubbles around the world were widely expected to lead to recession in the U.S. and a number of other countries in 2008.

2.0 Causes of financial crisis

In financial market, there is a strategic complementarily condition which affected to the financial crisis. In many cases, investors have incentives to coordinate their choices. For example, someone who thinks other investors want to buy many Japanese yen may expect the yen to rise in value, and therefore has an incentive to buy yen too.

If the investors who think like that much bigger, then there are less yen that had been bought, until there is no value for yen. Therefore, financial crises are sometimes viewed as a vicious circle in which investors avoid some institution or asset because they expect others to do so.

Another cause of financial crisis is leverage, which means borrowing to finance investments. It borrows in order to invest more, it can potentially earn more from its investment, but it can also lose more than all it has. Therefore, leverage magnifies the potential returns from investment, but also creates a risk of bankruptcy. Bankruptcy means that a firm fails to honor all its promised payments to other firms.

Another factor that believed to contribute in financial crises is asset-liability mismatch. That condition is a situation in which the risks associated with an institution’s debts and assets, which are not aligned appropriate.

The mismatch between the banks’ short-term liabilities (its deposits) and its long-term assets (its loans) is seen as one of the reasons bank runs occur (when depositors panic and decide to withdraw their funds quickly than the bank can get back the proceeds of its loans. The sample case is financing long-term investments in mortgage securities.

Many analyses of financial crises emphasize the role of investment mistakes caused by lack of knowledge or the imperfections of human reasoning. It has ever been happened in dot com crisis.

Governments have attempted to eliminate or mitigate financial crises by regulating the financial sector. Goal of regulation is transparency: making institutions’ financial situations publicly known, and to make sure that institutions have sufficient assets to meet their contractual obligations, through reserve requirements, capital requirements, and other limits on leverage. Some financial crises have been blamed on insufficient regulation, and have led to changes in regulation in order to avoid a repeat.

Fraud has played a role in the collapse of some financial institutions, when companies have attracted depositors with misleading claims about their investment strategies, or have embezzled the resulting income.

Many rogue traders that have caused large losses at financial institutions have been accused of acting fraudulently in order to hide their trades. Fraud in mortgage financing has also been cited as one possible cause of the 2008 sub prime mortgage crisis.

Contagion refers to the idea that financial crises may spread from one institution to another, as when a bank run spreads from a few banks to many others, or from one country to another, as when currency crises, sovereign defaults, or stock market crashes spread across countries. When the failure of one particular financial institution threatens the stability of many other institutions, this is called systemic risk.

Economists often debate whether observing crises in many countries around the same time is truly caused by contagion from one market to another, or whether it is instead caused by similar underlying problems that would have affected each country individually even in the absence of international linkages.

Some financial crises are believed to have played a role in decreasing growth that could have a recessionary effect on the rest of the economy. Those crises could be caused by currency crises and banking crises together, which can cause recessions.

In Islamic perspective, financial crises are caused by basic concept of conventional financial system, which is in the single transaction of conventional transaction. There are four factors that made transaction prohibited. The first is a prohibition in the substance (zat), such as khamr, alcohol, pork, carcass, and blood. Second is prohibition of riba, which appear if uncertain contracts converted to be certain contracts. Third is avoidance of gharar, which appear if certain contracts converted to be uncertain contracts. Usually it happens in exchange transaction. And the last is prohibition of gambling (maisir), usually it happens in zero sum game.[2]

3.0 Effect of financial crisis

3.1 Effect to the world

All type of crises mainly affected to the economic recessions. Especially for the respective countries who are experiencing the recession. The impact is different for each country. It is depend on the country’s economic condition, which impacted not only to the poor countries, but also to the developing countries, and the developed countries.

Example case of global crisis in the last 2008, could impacted more than 90 million people could be living in poverty by 2010. The impacted to the developing countries are:[3]

  • People are adapting livelihoods in order to cope but often into illegal or dangerous activities.
  • People are eating less frequently, less diverse and less nutrient-rich foods.
  • There are signs of rising domestic violence, tensions between groups, crime and drug and alcohol abuse.
  • Different countries are putting the blame for the crisis in very different places.
  • Recession in rich countries will hurt developing countries’ exports but it is also lowering the price of oil, reducing the severity of the impact on oil importing nations.
  • Access to trade credit is not a major problem for established garment and horticultural firms in Africa. It is however a serious problem for some Latin American firms.
  • Major global buyers are forcing developing country suppliers to absorb the bulk of the risks associated with the crisis.
  • China’s state enterprises are using the crisis as an opportunity to consolidate investments in Africa, particularly in the energy sector.

After ripple effects of a sub prime mortgage lending crisis in the U.S. began to be felt across the globe, housing values deflated, banks failed, credit froze, and layoffs spurred unemployment levels not seen in decades. While all of the accumulated evidence points to a deep global recession now, the recent downturn unfortunately has had a disproportionate impact on people aged 50+.[4]

3.2 Effect to individual

The above explanations are focusing in macroeconomic aspects, which is specific on the country level. We can consider that individual level is the last level who feels the financial crises effect. However, individual has the important decision in facing the financial crises and recession.

For the individual, the main problem is the changes of the purchasing power, which reflect to the changes of the lifestyle. In some countries, some people are eating less frequently, less diverse and less nutrient-rich foods.

Purchasing power could be caused not only by the rise of the daily need’s price, but also the decrement of the individual source of funds. Both are affected by financial crises, which make individual’s lifestyle changed to the unexpected condition.

In US, over the last 12 months, retirement accounts have lost $2 to $3 trillion in value. Between the 2nd quarters of 2007 and 2008, private pension fund assets declined by over half a billion dollars while state and local pension funds declined at rate of nearly $350 billion. In the current labor market, those aged 55 and over are losing their jobs at a higher rate than the young are.

Policymakers must determine whether the right vehicles for retirement savings are in place, what is required to rebuild consumer confidence to begin reinvesting in the market and our own futures, and how to encourage older people to stay in the workforce longer in an environment of high unemployment.

4.0 How to Protect Income

Financial crises is the worst caused for individual’s lifestyle. So that we as an individual, need to protect our income in order to stabilize our financial condition. Especially how to protect our income for retirement plan in global crises, is another thing that need to be discussed.

There are many approach methods in investment plan as a solution to protect our income. Which investment is one of the solutions that would be highlighted in this discussion? There are three types of period terms in investment plan. There are short terms, medium terms, and long terms.

4.1 Short Terms Investment

Short-term investments can be considered, if you need to make money quickly. Short-term investments allow you to invest an amount of money at a high yield rate of return, and gain access to the return sooner rather than later.

You might need short-term investments if you have a pressing need coming up in the near future. For example, if you might need a down payment for a house or car in a year or two, you could use short-term investment options. The period is usually between one up to ten years. This is most likely different with retirement investing. Some even choose to use short-term investment funds to supplement their retirement income.

Most people are comfortable with investing around ten percent of their total income. Then, choose the investment to use. It is best to take the amount and invest it into one particular investment. There are several short-term investment options out there, and the key to making money successfully is finding the best short-term investments.

The sample investments for short-term periods are stocks, securities, savings, deposits, and bonds. All of them have same characteristics. There are liquid in short time. Stock is the investment in stock exchange, which investors can buy and sell stock of any company. The characteristics are liquid, high risk, but it is high return. However, the investor must have knowledge of the market trends, company portfolio, and needs a lot of time to monitor any information that could be the key driver of the stock price’s movement.

Securities are similar with stock investment. The differences are in the process and the institution involved which affected to the investor. Securities consist of several stocks, which are combined in a portfolio. The portfolio is managed, monitored, and analyzed by fund manager. The benefits for investors are simple investment, low risk, does not need to have a complex knowledge, and it savings much time in monitoring activities. However, the return is not as high as stock investment.

In addition, the other samples are savings, deposits, and bonds. Where all of them are more liquid than the first two samples. These investments are the least risk and the least return. These are simple investments for anyone, who has money.

4.2 Long term Investment

The long-term investments account differs largely from the short-term investments account in that the short-term investments most likely will be sold, whereas the long-term investments may never be sold, which long-term investments are where diversification is helpful.

The sample investments for long-term periods are insurance, real estate, and equity. Insurance simply means joint guarantee. It is not a contract but an agreement for mutual help among the group, and can be visualized as a pact among clients who agree to jointly guarantee among themselves against loss or damage that may befall any of them. The basic objective is to pay for defined loss from a defined fund.[5]

The objective of the insurance is to protect the loss. In addition, for the modern insurance nowadays, the objective of the insurance is not only for protection, but also for investment. Insurance is combined with portfolio investment, which managed by fund manager. So insurance is categorized as low risk with low return investment. However, the return could be received in a long time. The benefits are less effort to have knowledge and savings time for monitoring.

Next investment is equity. Equity in this discussion means investment in direct investment in real business. Investors, who have money, give the money to the party who will run the business. Investment in equity is categorized as high risk and high return. Investor must have much knowledge about the business industry’s characteristics.

Most of investment in equity, investor will have a return in long period since in the early, management must build and setting the business up. This process needs much effort from investor to have a good analysis and invest more time.

The last is the investment in real estate. Real estate consists of three types. There are personal residence, income property, and speculative property. In the individual level, investment in real estate will make income for investors who have the property from the rental fee.

This investment is categorized as the long-term period investment, which potentially high return and potentially high risk if it were wrong managed. The operational cost in real estate is relatively higher than another investment and the operational process is wasting much time. In this traditional real estate, investor must have much money in the early to buy the property and operational cost.

Same with several stocks that combined in securities, real estate also could be managed by real estate investment trust to be sold to investor. This investment is simpler than traditional real estate. Investor does not need to invest time to maintain the property, and it is relatively liquid. The benefit for investor is less money to invest in the early, less of operational cost, and savings time.

The choice of investment has been determined in the above sections, both for short-term and long-term period. Moreover, how do we combine those investments as the optimum income, both for short term and long term as our retirement plan?

There are some combinations which could be combined depends on the investor’s preferences in facing the retirement. Retirement planning is a comprehensive analysis of the tax-effective strategies, which are available to assist you in achieving your goals for retirement; which the process includes a comprehensive review and analysis of your assets, liabilities, saving patterns and investment strategy in the context of your timing of your retirement, retirement income and your tolerance for investment risk.[6]

It means that retirement planning is a plan to ensure that we have enough money to spend when we will retire. It includes the amount to save and to invest in the diversified portfolio. It should also consider the future inflation rate, the life style expected etc. Retirement planning is one of the financial planning which focusing on wealth protection.

We must plan our retirement through several processes. First is setting of Retirement Plan Goals. The Second is analyzing information and calculating savings needed to meet the Objectives. Next is planning the distribution, ascertaining the best method to distribute that is best. Then, it is implementing the plan. The last is review the plan.[7]

However, the investment structure for the retirement plan must be considered for investor. In Islamic perspective, all each transaction must bee free from riba. Risk in retirement plan must be managed properly as mentioned in Surah Yusuf (12:67) and Surah Yusuf (12:47); (7 yrs good harvest,7 yrs for bad harvest).

Those risk factors that must be managed consist of four types. There are personal risks, property risks, liability risks, and investment risks. In order to keep economic stability in retirement, we could apply the portfolio theory. Diversification and tax management are the main point in managing portfolio investment, which mentioned in the section 4.1 and 4.2.

The portfolio preferences could be created by considering the types of returns (capital appreciation/long term/rental income), level of returns, and leveraging tool for using borrowed funds. However, there are several portfolio investments that must be managed properly, such as market risk (macro economic issues), specific risk (related with industry), and financing risk (cash flow). All of the retirement plan methods can contribute to minimize risk of the wealth planning management.

5.0 Conclusion

Therefore, with the purpose of financial stability in retirement, retirement planning, as part of wealth planning management is one of the best methods that individual can do to minimize risk from financial crises impact. Therefore, risk in individual level could be decreased.

One of the good impacts is the changes of purchasing power, which will be decreased. It means that the individual’s lifestyle is almost unchanged. For example eating frequently and nutrient-rich foods can be fulfilled.

At the end, the economic condition globally can avoid the recession. It is because of the stability in the macro and micro economic aspects.

6.0 Reference

Alhabshi, Syed Othman. 2009. Retirement Planning. Presentation Slide. INCEIF. Kuala Lumpur

http://en.wikipedia.org/wiki/Financial_crisis (accessed 3 June 2009)

http://www.aarpinternational.org/resourcelibrary/resourcelibrary_show.htm?doc_id=860569 (accessed 3 June 2009)

http://www.research4development.info/news.asp?ArticleID=50393 (accessed 3 June 2009)

Karim, Adiwarman. 2004. Bank Islam Analisis dan Keuangan, RajaGrafindo Persada, Jakarta.

Razak, Shaikh Hamzah Abdul. 2009. Wealth Planning and Management. INCEIF. Kuala Lumpur.

Rosly, Saiful Azhar. 2005. Critical Issues on Islamic Banking and Financial Market. Dinamas. Kuala Lumpur..


[1] http://en.wikipedia.org/wiki/Financial_crisis (accessed 3 June 2009)

[2] Karim, Adiwarman. Bank Islam Analisis dan Keuangan, RajaGrafindo Persada, Jakarta, 2004.

[3] http://www.research4development.info/news.asp?ArticleID=50393 (accessed 3 June 2009)

[4] http://www.aarpinternational.org/resourcelibrary/resourcelibrary_show.htm?doc_id=860569 (accessed 3 June 2009)

[5] Rosly, Saiful Azhar. 2005. Critical Issues on Islamic Banking and Financial Market. Dinamas. Kuala Lumpur.

[6] Alhabshi, Syed Othman. 2009. Retirement Planning. Presentation Slide. INCEIF. Kuala Lumpur

[7] Razak, Shaikh Hamzah Abdul. 2009. Wealth Planning and Management. INCEIF. pg 270

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