All About Actuarial Gain/ Loss
I would like to thanks all of you for liking my previous article on Gratuity, now I would like talk on Actuarial
Gain or Loss arising on liabilities:- Technical word for common people and a
most often used word in the offices of Actuarial consultancies serving in the
area of Pension & Employee Benefits.
Actuarial Gain/Loss on liabilities
is defined in Ind AS 19/AS -15 (Revised
2005)/ IAS-19 (Revised 2011) as
follows:-
“ Actuarial gains and losses are
changes in the present value of defined benefit obligations resulting from:-
(i)
experience
adjustment (the effects of differences between the previous actuarial
assumptions and what has actually occurred); and
(ii)
the effects of
changes in the actuarial assumptions.”
Every
Actuarial student/ professional working in the area of Pension and employee
benefits aims to minimize actuarial gain/loss arising on liabilities. They try
to set assumptions, after analyzing past data and discussing with the client or
management, in such a manner so as to have Actuarial Gain/Loss → (tend towards) 0. For Common People Actuarial Gain/Loss is just the
residual item in the given below table. Despite Actuarial Gain/Loss being an
unavoidable component, it is more significant figure for an Actuary rather than
assuming it to be a residual item. It is a useful guide/barometer to test the
Actuarial Liability before finalizing the report. Actuarial Gain/loss summarizes the
significant changes that have occurred in during the time period of calculation
of opening liability and closing liability.
Table 1:-
Opening defined benefit
obligation
|
100
|
||||
Current Service Cost
|
10
|
||||
Interest Cost
|
5
|
||||
Remeasurement
(gains)/losses:
|
|||||
Actuarial (gains)/losses
arising from changes in demographic assumptions
|
-
|
||||
Actuarial (gains)/losses
arising from changes in financial assumptions
|
-
|
||||
Actuarial (gains)/losses
arising from experience adjustments
|
75
|
||||
Past service cost,
including losses/(gains) on curtailments
|
-
|
||||
Benefit Paid
|
(70)
|
||||
Closing defined benefit
obligation
|
120
|
Can Actuarial Gain/Loss arising on
liabilities ever be Zero?
Is
it possible to set assumptions in a way so as to reduce Actuarial Gain/Loss to
Zero? To answer this question, first we have to understand what this Actuarial
Gain/Loss Comprise of:-
Actuarial
Gain/Loss comprise of all those factors which are not in control of management
and an Actuary. Since Actuary is a professional who looks into future
contingencies can certainly assist management in bridging the gap between
Actual vs Expected.
As
evident from the definition above, actuarial gain/loss comprises of following
two components:-
(a) Actuarial Gain/Loss arising from changes in Assumptions
and,
(b) Actuarial Gain/Loss arising from Experience Adjustment
These
Components of Actuarial Gain/Loss are briefly described below:-
1.
Change Due to Actuarial Assumptions:- The major cause of Actuarial Gain/Loss is change in
Actuarial Assumptions from calculating of Opening Liability to Closing
Liability.
Actuarial
Assumption comprises change in Financial Assumptions, (like Salary or Benefit
Escalation Rate and Discount Rate) and Change in Demographic Assumptions ( like
mortality rates, morbidity rate, disability rate and Employee Attrition rates).
More details on actuarial assumptions can be found from my previous article
titled “All About Gratuity” published in February 2017 edition of Actuary India
magazine.
If
there is any change in actuarial assumption from opening liability to closing
liability due to reasons best explained by Management and Actuary then there
will be actuarial gain/loss arising due to change in financial or demographic
assumptions.
2.
Change Due to experience adjustment:- It comprises of reasons which are beyond actuarial
assumptions i.e change caused by actual
experience during the inter-valuation period being different from the
assumptions used for determination of value of Obligation e.g. If Actuarial Liability is determined with
a salary escalation rate of 10%(say) uniformly for all employees and Actual experience
reveal that some employees have different than 10% increase in salary then
Actuarial Gain or loss due to experience adjustment is inevitable.
So,
coming back to our question on whether Actuarial Gain/Loss can ever be Zero? I
am here to discuss the matter by quoting examples of two important Defined
Benefits in the Indian Context:-
(a)
Gratuity (as per
Gratuity Act 1972)
(b)
Leave Encashment
(Company specific rules)
Gratuity:- Assuming Salary/benefit escalation rate and employee
attrition rate following the long term assumptions and no new hiring of new
employees during the year. There are two major factors resulting in Actuarial
Gain/Loss:-
(i)
Discount rate:-
Discount rate is determined in compliance of para 78 of AS15 (Revised 2005) /
para 83 of Ind AS 19 issued by ICAI which depends on Government Bond Yields.
Since yields on Government bonds are subject to Market Risk and Estimated term
also vary with time. Change in discount rate may result in Actuarial Gain/Loss
due to change in financial assumption.
(ii) Mortality:- Mortality rates in use for
valuing Actuarial Liability is decade
old
and may not truly represent mortality characteristics of every enterprise.
Companies too rarely have proper maintenance of past records to help actuary in
adjusting the corresponding mortality rates. No separate female mortality table
further increase the deviance. So Actual deaths vs Expected Deaths further add
to Actuarial gain/loss and may result in Actuarial Gain/Loss due to experience
adjustment.
Due
to above two reasons it becomes difficult to have Zero Actuarial Gain/Loss. Other causes of Actuarial Gain/Loss can
be changes in Salary Escalation Rate, Employee Attrition rate etc.
Leave Encashment:- In addition to the above key factors as mentioned in
Gratuity ,which are also direct relevant in Leave Encashment valuation, one
more significant factor result in Actuarial Gain/Loss being non-zero in case of
Leave Encashment Valuation.
CTC Salary: Actuarial Liability of Leave Encashment comprise various
components out of which one component is valued at CTC : Leave Value at
Availment of leaves (generally Sick Leaves can only be availed not encashed).
CTC Salary is not equal to the salary which is used in computation of actual
payment (Benefit Paid) of Leave Encashment to employees in the event of exit
from service. Therefore Benefit Paid (as shown in Table 1) of Leave Encashment
during the period excludes an amount equivalent CTC Salary minus Qualifying Salary for Leave Encashment. Due to this
inherent contradiction, a residual item is unavoidable, which some may put in
Actuarial Gain/Loss.
At
the end I would like to express my views on rising Gratuity Liability after 7th
Pay Commission implementation for Central Government Employees. Remuneration of Central Government employees are governed
by CCS Pension Rules and are revised from time to time with the coming of Pay
Commissions. 7th Pay Commission an up gradation of the earlier
6th pay commission brought many changes. Gratuity being an
important retirement benefit in the Indian Context was targeted structurally in
the new pay commission:-
Some Key Changes under 7th Pay Commission and
their effect on Gratuity Liability:-
1. DA Merged with Basic:- Basic Salary (including Basic Pay and Grade
Pay) under CCS Pension Rules generally increases by 3% Compound interest while
DA being a certain %age over Basic increases by certain Simple Interest. Once
DA gets merged with Basic, price escalation till retirement takes into account
of compounding effect of Basic Pay and results in an substantial increase in
liability.
2. Change in Gratuity Ceiling:- Before 7th Pay Commission
Monetary Ceiling on Gratuity was restricted to Rs.10 lakh which means a government employee
cant draw a Gratuity of more than Rs.10 lakh in their life time. With the
changes in the 7th Pay Commission, this monetary ceiling has
been increased to Rs.20 lakh. With
this change Gratuity liability of the Government employees specially ones
drawing higher salary will result in an increase in liability. There is also a
special provision under 7th pay commission which says “The
monetary ceiling on Gratuity will increase by 25% whenever DA rises by 50% of
the basic pay”. This special provision will certainly act as a
catalyst for pushing the liability further up and tending the Gratuity
liability towards the Gratuity Liability with no ceiling!
3. Change in rates in case of Death Gratuity:- Earlier for an employee dying during
service period in the interval “5 years or more, but less than 20 years” death
gratuity was admissible as 12 times of “emoluments”, now
under 7th Pay Commission this interval is break down as under
:-
5
years or more, but less than 11 years
|
12
times of 'emoluments'
|
11
years or more, but less than 20 years
|
20
times of 'emoluments'
|
With this new
change, the Gratuity liability of an employee for the reason of Death will
increase.
Falling of government bond yields resulting in falling of interest
rate of discounting will again cause an increment in Gratuity Liability.
The Consolidated effect of the above changes may bring an increase
in Gratuity liability of appx 2.5 times the liability reported in the previous
financial year. Actual increase may further increase if data has high
composition of employees with large salaries and large service period.
Views express in this article are mine and not
necessary refer to my current or previous employer.