All about Gratuity Valuation you need to know!!
Hello friends, I am here to talk about Gratuity Valuation from an Actuarial Perspective.
Gratuity is one of the post retirement defined benefit plan. It is received by an employee from his/her employer in gratitude for the continuous services offered by the employee in the company. It is one of the retirement benefits offered by the employer to the employee upon leaving his job. An employee may leave his job for various reasons, such as - retirement/superannuation, for a better job elsewhere, on being retrenched or by way of voluntary retirement or due to unfortunate death or disablement.
Etymology and History of Gratuity in India
The etymology for the "gratuity", derived from a Latin word ‘Gratuitas’ which simply means a ‘Gift’. Since an employee sacrifices prime time of his life for the development, prosperity and betterment of his employer, employer pays his employee gratuity as a graciousness or gift to him, when he no longer serves him.
Gratuity scheme was introduced in those establishments only where the employers were so kind and generous to the workers or there was an agreement between the employers and the workers. There was no general legislation for the payment of Gratuity to all industrial workers. In due course of time, it was felt the workers should get gratuity as a right in return of their long dedicated services to the industry.
The need for Gratuity as a statutory right was firstly felt by Kerala, State performing very well in socio- economic indicators, and enacted the Kerala Industrial Employees Payment of Gratuity Act, 1970 making gratuity a statutory right of the employees. Later, West Bengal Government enacted the West Bengal Employees Payment of Gratuity Act, 1971 relating to the subject. In the meanwhile Central Govt. felt that there should be a uniform central legislation for the whole country instead of state legislations. Central Government realized & passed central legislation on the Payment of gratuity. The bill was drafted on the basis of the West Bengal Employees’ Payment of Gratuity Act 1971 with some modification which was in the light of the views expressed at the Indian Labour Conference. Accordingly, the Payments of Gratuity Act, 1972 was enacted which was come into force on September 16, 1972.
Benefit formula under Gratuity
Qualified monthly salary (last drawn)* (15/26)* Completed years of service (including part of year in excess of six months)
Since this benefit depends upon last drawn monthly salary and is service linked, it gets changed drastically from the time when the employees join and the time at retirement due to annual increase in salary and increasing service period.
Actuarial Valuation of Gratuity Benefit
Gratuity is payable to an employee on termination of his employment after he has rendered
Continuous service for not less than five years:
*On his superannuation
*On his resignation
*On his death or disablement due to employment injury or disease, here vesting condition (of 5 years) does not apply.
According to Accounting Standard 15 (Revised 2005) , Gratuity is an Post Employment Defined Benefit Obligation and need to be Actuarially valued. It is amply clear from Para 49 of AS 15 (Revised 2005) which read as under:-
“Accounting for defined benefit plans is complex because actuarial assumptions are required to measure the obligation and the expense and there is a possibility of actuarial gains and losses. Moreover, the obligations are measured on a discounted basis because they may be settled many years after the employees render the related service. While the Standard requires that it is the responsibility of the reporting enterprise to measure the obligations under the defined benefit plans, it is recognised that for doing so the enterprise would normally use the services of a qualified actuary.”
Method used for Gratuity Valuation is Projected Unit Credit Method which can be defined as method which considers each period of service as giving rise to an additional unit of benefit entitlement and measures each unit separately to build up the final obligation.
Assumptions involved in Gratuity Valuation:
- Salary Escalation rate which includes inflation, merit and promotional increase.
- Attrition rate
- Discount rate (As per para 78 of AS 15 (Revised 2005))
- Mortality and disablement rate.
To perform actuarial valuation of Gratuity we first have to form a multiple decrements table showing appropriate rates for mortality, disablement and attrition. These assumptions generally depend on the past trends and expectations in future relating to business of the entity being investigated.
Then we have to calculate Salary Escalation rate based on the past years data and likely trends in future considering impact of inflation and other economic factors.
Having known the 3 assumptions we have to build a model to find the estimated term of liabilities to determine discount rate based on government bond yields (as per para 78 of A.S. 15 (Revised 2005) issued by I.C.A.I)
So after knowing all the actuarial assumptions (Demographic and financial) and properly scrutinizing the data (Correcting all error and omissions in the data by discussing with the client), we can run our model to determine the liability.
Now I, Conclude with some amendments in the act, being required from time to time, to meet with the growing needs of the employees. Gratuity benefit is usually payable at the time of retirement. Since, at the time of retirement employee generally has no source of regular income and due to old age- increasing medical expenses, increasing family commitments (like daughter’s marriage) and increasing inflation to meet with day to day expenses. So to cope up with all these uncertainties, Gratuity, act as one of the cushions to meet necessary expense as a single one time payment. The rules and regulations being prescribed in Gratuity Act 1972 need to be amended time to time and labour ministry tries to provide full justice by making amendments to the above act, in the national Parliament. Some of the amendments in the Payment of Gratuity Act 1972 are as follows:-
The first amendment made by the Payment of Gratuity (Amendment) Act, 1984 inter alia provides for raising the wage limit for coverage from Rs 1000/- to Rs 1600/- per month and appointment of Inspectors. The second amendment made by the Payment of Gratuity (Second Amendment) Act, 1984 inter alia re-defined the term ‘continuous service’ and provided for grant of exemption to a class of employees from the operation of the Act. The third amendment made by the Payment of Gratuity (Amendment) Act, 1987 inter alia provided for:-
(a) Raising the wage limit for coverage from Rs 1,600/- to Rs 2,500/- per month, which was further raised to Rs 3,500/- p.m. .
(b) Replacing the ceiling of twenty month’s wages for payment of gratuity by a monetary ceiling of Rs 50,000/-
(c) Making it obligatory for the employers to pay simple interest at a specified rate if the gratuity is not paid within 30 days from the date it falls due.
(d) Compulsory insurance/setting of gratuity fund for payment of gratuity.
In later amendments wage limit was removed all together and ceiling limit was revised from time to time. Ceiling limit was raised to Rs 100,000 from Rs 50,000 in 1994 and further raised to Rs. 3,50,000 in 1997. It was increased to Rs. 10,00,000 in 2010 and has been revised to Rs. 20,00,000 in 2016 for govt. employees.
Hope this article helped in knowing more about role of actuary in Gratuity valuations. Please feel free to discuss any queries and suggestions at guptarajat9617@gmail.com
Views expressed in this article are mine and not necessarily refer to my employer.
Thanks & Regards
Rajat Gupta
Actuarial Analyst
M.L. Sodhi Consulting Actuary
guptarajat9617@gmail.com
+91-8447077073
