All about Actuarial Gain/Loss

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 7^th 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. 7^th Pay Commission an up gradation of the earlier 6^th 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 7^th 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 7^th 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 7^th 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 7^th 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 7^th 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.

Actuarial Liability of Gratuity under 7th Pay Commission

7^th Pay Commission and Gratuity Liability

Remuneration of Central Government employees are governed by CCS Pension Rules and are revised from time to time with the coming of Pay Commissions. 7^th Pay Commission an up gradation of the earlier 6^th pay commission brought many changes. Gratuity being an important retirement benefit in the Indian Context was targeted structurally in the new pay commission:-

Some notable changes in the Gratuity Benefit are as under:-

Gratuity as per 6^th Pay Commission:-

(a) Service Gratuity- No pension is admissible to a permanent employee who retires before completion of 10 years' qualifying service. Instead, a lump sum payment known as Service Gratuity at the rate of half-month's emoluments for every completed six-monthly period of qualifying service is admitted. This gratuity is in addition to retirement gratuity admissible to those who have completed 5 years' qualifying service. Since it is not possible to find an employee with less than 10 years of service with joining before 31.12.2003, it may be considered as non existent.

(b) Retirement Gratuity- Retirement Gratuity is admissible to all employees who retire after completion of 5 years of qualifying service at the rate of 'one-fourth' of emoluments for each completed six-monthly period of qualifying service subject to a maximum of 16.5 times 'the emoluments' or `10 lakhs . Emoluments include DA on the date of cessation of service.

(c) Death Gratuity- Death Gratuity is admissible in case of death in service of an employee at the following rates: -

(i) Less than one year

2 times of 'emoluments'

(ii) One year or more, but less than 5 years

6 times of 'emoluments'

(iii) 5 years or more, but less than 20 years

12 times of 'emoluments'

(iv) 20 years' or more

Half of emoluments for every completed six-monthly period of qualifying service subject to a maximum of 33 times 'emoluments' or `10 lakhs whichever is less.

(d) Gratuity in no case shall exceed `10,00,000/-

Gratuity as per 7^th Pay Commission:-

(a) Retirement Gratuity- Retirement Gratuity is admissible to all employees who retire after completion of 5 years of qualifying service at the rate of 'one-fourth' of emoluments for each completed six-monthly period of qualifying service subject to a maximum of 16.5 times 'the emoluments' or `20 lakhs, whichever is less. Emoluments include DA on the date of cessation of service.

(b) Death Gratuity- Death Gratuity is admissible in case of death in service of an employee at the following rates: -

(i) Less than one year

2 times of 'emoluments'

(ii) One year or more, but less than 5 years

6 times of 'emoluments'

(iii) 5 years or more, but less than 11 years

12 times of 'emoluments'

(iv) 11 years or more, but less than 20 years

20 times of 'emoluments'

(v) 20 years' or more

Half of emoluments for every completed six-monthly period of qualifying service subject to a maximum of 33 times 'emoluments' or `20 lakhs whichever is less.

(c) The monetary ceiling on Gratuity will increase by 25% whenever DA rises by 50% of the basic pay.

Some Key Changes under 7^th 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 7^th Pay Commission Monetary Ceiling on Gratuity was restricted to `10 lakh which means a government employee cant draw a Gratuity of more than `10 lakh in their life time. With the changes in the 7^th Pay Commission, this monetary ceiling has been increased to `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 7^th 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 7^th 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.

Hope this article helped in analyzing effect on Gratuity liability after 7^th pay commission implementation.

Views expressed in this article are mine and not necessary refer to my employer.

                                                                                    

Rajat Gupta

Manager: Actuarial Services

                        M.L. Sodhi Consulting Actuary

Actuarial Valuation of LTC Benefits: - Challenges Involved

LTC refers to Leave Travel Concession Benefit in the Indian Context. It is a type of employee benefit given to employees (mostly in case of public sector entities) for visiting home or Any where in India within a given block. Actuarial Valuation of LTC Valuation comes with many challenges which I am going to discuss herein below.

Before knowing the challenges of a LTC plan, I will like to quote an example of a LTC Plan. Other plans with similar structure are generally provided by different entities.

LTC Plan Provision:-

LTC is admissible to employees and members of their families once or more than once in a block period, generally it is two to four years with some extended time frame. Employees are provided the options like:-

(a)    Visit to home town

(b)   Visit to any place in India/Overseas

This may/may not be subject to maximum distance as per his/her entitlement

It can be done by payment of Cash assistance in case of actual journey.

It may also include entitlement of LTC to children of the employees from their place of study to place of posting of employee.

Besides this, employees may also be allowed to carry forward the non-availment of LTC in a block period to next block. Maximum leaves for LTC can also be ceiled while availing LTC.

Typical challenges involved in its Valuation:-

1)      What type of Plan it is ?
Short Term, Long Term, Post Retirement, Other Long Term Employee Benefit???

Since the benefit is not available after retirement and the block period exceeds time frame of one year, it qualifies the category of Other Long Term Employee Benefit. The definition is contained in AS 15 (revised 2005) :-

“ Other long – term employee benefits are employee benefits (other than post – employment benefits and termination benefits) which do not fall due wholly within twelve months after the end of the period in which the employees render the related services.”

2)      Non uniformity of Plan Provision?

Plan Provision that companies use for providing such benefit to their employees are non standardized and non uniform. Unlike Gratuity, there is no specific Act governing LTC Benefit. Companies use their discretion by adding more benefit or restrictions or vesting as they desire.

3)      Valuation to be done by projecting till retirement or till the current block?

      Here  “Accrual concept” a fundamental accounting assumption provide guidance,   

      which says that the cost of providing benefits to employees in return for the services   

      rendered by them in an accounting period should be accounted for in that period.      

   

      AS- 15 recognizes that the liability towards employee benefits should be provided as         

      and when the services are rendered. So, the accrued service of employee provide

      his/her entitlement to the benefit of the current block only not on all the blocks he/she

      is expected to get entitle till retirement. Hence, liability to be determine only for the 

      current block not of future blocks he may get till the date of retirement. Different

      views can be found on this particular point and may result in diverse practices.

4)      Methodology to be used?

AS – 15(Revised 2005), Ind AS 19 and IAS 19 (Revised 2011) recognizes Projected Unit Credit Method to determine the liability.

5)      Modeling?

 Modeling of LTC Benefit is complex by the fact of uncertainty involved in evaluating rate of availment, expenses involved, rate of increase of expenses, factors to be considered while determining rate of increase of expenses, involvement of family/ spouse and their respective mortality rates, determination of estimated term for determining discount rate, benefit structure not linked to salary, leave encashment if company policy etc.

6) Non Availability of past experience?

Many a times companies are unable to provide past experience resulting in increasing ambiguity/ complexity to workout required averages and related transition rates. Even if they have past experience, improper maintenance of proper accounts, which is generally a case with PSE, results in providing incomplete/ truncated data and information.

Views expressed in this article are mine and not necessary refer to my employer. Please feel free to contact for any queries or discussion!

Rajat Gupta

+91-8447077073

Manager: Actuarial Services

                        M.L. Sodhi Consulting Actuary

                                                                                                            guptarajat9617@gmail.com

                                                                                                                        

Demonetization and Gratuity Liability

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:-

1. Salary Escalation rate which includes inflation, merit and promotional increase.
2. Attrition rate
3. Discount rate (As per para 78 of AS 15 (Revised 2005))
4. 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

guptarajat9617@gmail.com

+91-8447077073