Shariah Compliant Pensions Simplified – part 2

NOTE: This information should not be regarded as financial advice and is merely a learning and awareness initiative.


Islam is a holistic framework with principles and guidelines for all facets of life such as worship, social relationships, business, investing and more. The laws governing investments are underpinned by an overarching principle of encouraging beneficial activity and discouraging harmful activity. Islam encourages investments in companies and funds which bring benefit to people, the society, the economy, the environment, nature and life in general. Investments are discouraged in companies which result in some form of harm to individuals, communities, the economy, the environment, nature and life in general. It is this vision of encouraging benefit and dissuading harm which underpins the specific guidelines for investments. This very principle underpins the rulings governing asset classes found in pension portfolios.

Pension Portfolio Asset Compositions & Shariah Opinions

Assets behave differently; each asset has unique characteristics and reacts differently to factors such as world events, politics, economics and interest rate moves. Some are more volatile – their value rises and falls to a greater extent – than others. As a result, asset classes have different levels of risk and potential returns[i]. Each asset has a unique risk/return profile. Investment means trade-offs. Usually, you must take on more risk to aim for a higher return. Investment managers like to diversify a portfolio to bring low or negative correlation between the assets. Low or negative correlation allows for overall growth and flexibility of the fund to weather market conditions impacting certain asset classes. Conventional pension fund portfolios are generally composed of the following asset classes:

  1. Equity

Equity is a share in the ownership of a publicly quoted company. Equity can receive capital growth through increases in the share price, and it can receive income in the form of dividends. Equity funds generally invest across a range of various countries, regions, industries and investment styles as a way of diversifying or spreading risk. Equity is usually higher risk and thus potentially higher returns.    

From a Shariah compliance perspective, equity must pass Shariah screening tests before it can be a viable investment. These tests include reviewing the core business activity of the company and assessing the financials of the company to ensure it falls within the acceptable thresholds of Shariah screening tests.

  1. Bonds

A bond or fixed interest security is an instrument of debt issued by a company or government that is repayable after more than one year. Examples of bonds include gilt-edge bonds, corporate bonds and debentures. Whereas owners of equity have the right to a company’s assets, bondholders are effectively lending a company money and so own its debt.  Bondholders are paid coupons. Bonds are associated with low risk and low returns.

Bonds issued by the UK government are known as ‘gilts’ which have a lower risk of default and lower yields than corporate bonds which are issued by companies.

Bonds are non-Shariah compliant investments which involve lending at a cost, which is Riba.

  1. Cash

Cash funds invest in physical currency, bank accounts, savings accounts, money market funds, cash ISAs and cash deposits. A typical cash investment would be in a bank account, with a rate of interest. These are considered safe investments and offer very low interest. From a risk perspective, cash does not pose a capital risk, and is very liquid and therefore easily accessible. However, they are susceptible to inflation and therefore provides limited growth in real terms[ii]. Savings accounts, cash ISAs, money market funds are all non-Shariah compliant investments. Such investments accrue interest on the capital and again classify as Riba investments.

  1. Property

Investment in property can be direct or indirect. Direct property investment refers to investing in brick and mortar directly. Indirect property investment refers to investment in the equity of companies which own, manage or develop property. Most of the UK’s largest property companies have become what’s known as a REIT since they were launched in this country in 2007. To become a REIT, at least 75% of a company’s profits must come from property rental, and 75% of its assets must be involved in property rental. REITs also have to pay out 90% of their property rental income to their shareholders as dividends[iii].

Property in the investment world generally refers to commercial property, which is property used for business. There are three types of commercial property:

  1. Retail property – shops, shopping centres and retail parks
  2. Office property – Offices and business parks
  3. Industrial property – industrial estates, warehouses and factories

According the AAOIFI Sharia Standard 9 on Ijarah, the tenant’s services must be Shariah-compliant for the lease and rental to be lawful. The Standard states:

5/1/1 The leased asset must be capable of being used while preserving the asset, and the benefit from an Ijarah must be permissible by Shariah. For example, a house or a chattel may not be leased for the purpose of an impermissible act by the lessee, such as leasing premises to be used as headquarters by an Institution dealing in interest or to a shopkeeper for selling or storing prohibited goods, or leasing a vehicle to transport prohibited merchandise.

Some contemporary Hanafi jurists differ with the above – based on the view of Imam Abu Hanifah – and are of the view that technically speaking, the tenant’s services need not be Shariah-compliant for the rental to be lawful. They are of the view that it is permissible to lease property to non-Muslims tenants who are offering non-Shariah compliant services. They argue that the rental is in lieu of the usufruct of the property, not the service delivered. Since the usufruct is delivered to the tenant, rental becomes due irrespective of what they do. Furthermore, the services are performed by the tenant, and the landlord is not accountable for them[iv].

  1. Alternatives

‘Alternatives’ is a broad name to address non-traditional assets[v]. They typically include private equity, hedge funds and commodities. These asset classes are growing in importance as they provide diversification benefits away from the traditional asset classes of equities and bonds.

Private equity involves an equity investment in a potentially high-growth, unlisted companies which are generally start-ups or in the early years of their lives. Hedge funds are funds which use complex investment strategies such as holding short positions, employing leverage and targeting absolute returns instead of a benchmark or index. Commodities is any bulk good traded on an exchange. These commodities are usually traded on the futures markets in derivative contracts.

Private equity is subject to Shariah screening tests. The core business activity and financial ratios must be screened to ensure Shariah compliance. Conventional hedge funds deploy a number of investment strategies such as long-short, distressed debt, direct lending, global macro, merger arbitrage and many others, the majority of which are non-Shariah compliant. Commodity trading are generally traded via futures contracts. The majority of Shariah scholars are of the view that conventional Futures and Forward contracts are not Shariah compliant. This was the resolution of the International Islamic Fiqh Academy as well as the Islamic Fiqh Academy of Muslim World League. The AAOIFI Standards explicitly state the non-compliance of such contracts. Forwards and futures are prone to the Shariah prohibition of trading before possession. As such, these contracts contain Gharar (gross uncertainty). Shariah scholars argue that these contracts contain elements of Qimar in that they are zero-sum games. A further non-compliance factor in futures and forwards is the existence of a debt for debt trade where parties offset and close their positions before delivery of the underlying assets[vi].

Shariah Compliant Portfolio Compositions

Since many of the asset classes above are non-Shariah compliant, a Shariah compliant pension is generally invested in a smaller pool of assets which are reviewed and certified as compliant by the respective Shariah boards. These assets include:

  1. Shariah compliant equity

Equity found in Shariah compliant portfolios are those which have passed the Shariah screening tests. These equities can be from all regions across the world and span a number of sectors. The common sectors include information technology, health care, communications, industrials, energy and materials.

  1. Property

Generally, investments in property take place through Shariah compliant REITs which are referred to as Islamic REITs (I-REITs). Islamic REITs are collective investment vehicles that pool money from many investors to buy, manage and sell commercial properties. The main difference between I-REITs and conventional REITs lies in the fact that I-REITs must only include Shariah compliant activities. The other main differences are that an I-REIT has a Shariah board, the tenants must be delivering Shariah compliant services, Takaful is the default form of insurance for such investments when available and the financing of such REITs must be done using Shariah compliant products.

  1. Sukuk

The AAOIFI Shariah Standard No.21 proposes an alternative to bonds by stating:

“The Shari’ah substitute for bonds is investment Sukuk.” The overall risk profile and economic return for a Sukuk investor has some similarities albeit differences to a conventional bond where the bondholder is a debtor of the issuer.

AAOIFI defines Sukuk as being: “Certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activities.” Unlike a conventional bond (secured or unsecured), which represents the debt obligation of the issuer, a Sukuk technically represents an interest in an underlying funding arrangement structured according to Shariah, entitling the holder to a proportionate share of the returns generated by such arrangement and, at a defined future date, the return of the capital.

Sukuk is a financial instrument that shares characteristics with bond and stock which are issued to finance trade or the production of tangible assets. Similar to a bond, Sukuk has a maturity date and in some of them the holder will receive a regular income over the period and a final payment at the maturity date. While the conventional bonds price is determined only by the creditworthiness of the issuer, Sukuk price is determined by the creditworthiness of the issuer and the value of the asset. Although Sukuk is also similar to stocks in the sense that it represents ownership and no guarantee of a fixed return (at least theoretically and in the standard model of Sukuk) but stocks have no maturity date. Sukuk also have to relate to a specific asset, project or service.

Among the benefits of Sukuk are that most Sukuk are a tradable capital market product providing medium to long-term fixed or variable rates of return. It is assessed and rated by international rating agencies, which investors use as a guideline to assess risk/return parameters of a Sukuk issue. It has regular periodic income streams during the investment period with easy and efficient settlement and a possibility of capital appreciation of the Sukuk. Finally, most Sukuk are liquid instruments and tradable in secondary market.

  1. Shariah compliant savings accounts

Cash investments are made into Shariah compliant savings accounts which use a typical Wakalah bil Istithmar (investment agency) or Mudharabah structure to invest the funds. Commodity Murabahah is also used in the money market for liquidity management.


The next article will review current Shariah compliant pensions available in the UK.







[iv]Hashiyah ibn Abidin 6/392



Related Posts

Leave a Reply