Previous year have seen lot many unexpected events
and was full of uncertainties. Starting from changing of Central Bank Governor
(got popular with term Rexit) following with Brexit , Cross Border Surgical
Strike, US Elections and ending with demonetization. Demonetization remained
one of the most debatable topics at the end of 2016. Being student of Economics
and Actuarial Sciences, I would like to share the impact of demonetization on
Gratuity liability through this article.
Brief
about Gratuity
Gratuity is one of the
post retirement defined benefit plan (legally enforced by Gratuity Act 1972 to
entities where number of employees are greater than 10). 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.
Benefit
Formula under Gratuity Plan: - 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.
Since Gratuity is a defined benefit plan, its
valuation 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.
Actuarial
Assumption 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.
Gratuity valuation is subjected to market volatility
due to assumption underlying Discount rate. Para 78 of AS 15 (R 2005) says that
“The rate used to discount post-employment benefit obligations (both funded and
unfunded) should be determined by reference to market yields at the balance
sheet date on government bonds. The currency and term of the government bonds
should be consistent with the currency and estimated term of the
post-employment benefit obligations.”
Large amount of financial inclusion due to
demonetization will result in lowering of govt bond yields and would cause
severe impact on liability with rising obligations and hence increasing actuarial
loss.
The above impact can be visualized from a very
simple example:-
Suppose the plan provision of an employee named
Dummy is as follows:-
Normal Retirement Age
|
60 Years
|
Salary for calculation
of gratuity
|
Last drawn monthly
salary as provided by the enterprise
|
Vesting Period
|
5 years of service
|
Benefit on normal
retirement
|
(15/26) x salary x
number of years of completed service.
|
Limit on Amount of
Gratuity
|
Maximum Gratuity is
restricted to `10,00,000/-
|
Details of employee named Dummy:-
Age
:- 40
Monthly Qualifying Salary :- 30,000 per month
Date of Joining :- 1/1/2010
Date of Valuation :-
31/12/2016
Actuarial Assumption:-
Assuming no possibility of death, disability and
attrition for simplicity
Salary escalation rate: - 10%
Discount rate: - Case 1 = 7%, Case 2 = 8%, and Case
3 = 9%
Since age of employee is 40, service period as on date
of valuation is appx 7 years and outstanding service as on date of valuation is
60-40 = 20 years.
Therefore expected payout at retirement would be:-
Min(30000x(15/26)x7x(1+0.1)^20, 10,00,000) = min(
815062.5, 10,00,000 ) = 815062.5
Now expected present value for Case 1 will be =
815062.5/ (1.07^20) = 210627.6
Similarly for Case 2 and Case 3 will be 174870.2 and
145432.3 respectively
Liability Analysis
|
Case 1
|
Case 2
|
Case 3
|
|
Discount Rate
|
7%
|
8%
|
9%
|
|
A
|
Liability
|
210627.6
|
174870.2
|
145432.3
|
B
|
Change (Previous Case
- Current Case)
|
-
|
35757.44
|
29437.87
|
C
|
% age Change (B/A)
|
-
|
20.45%
|
20.24%
|
So based on the above analysis we can see that 1%
change in discount rate can result up to 20% change in liability. Impact can be
more severe if a large group is to be considered and assumptions for
demographic assumptions are allowed to play their role, which is generally the
case in such valuations.
Since discount rate is inversely proportional to
liability, so falling discount rate will result in rising of the entity’s
liability. If discount rate falls, other assumptions remaining unchanged, an
actuarial loss will be created. Thus due to rising of actuarial liability,
greater provisioning will be required to cushion the retirement benefit fund
against unfortunate contingencies. Due to this demonetization government bond
yield has fallen from earlier 8% (appx) to now 7% (appx) which will directly
show its impact on the rising of the Defined Benefit Liabilities. Hope this
article helped in understanding the effect of Demonetization or market
volatility on actuarial liabilities. Views expressed in this article are mine
and not necessary referred to my employer.
Please feel free to express your views on the same.
Thanks & Regards
Rajat Gupta
Actuarial Analyst
M.L. Sodhi Consulting Actuary
+91-8447077073
