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:

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 7thPay 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. 7thPay Commission an up gradation of the earlier 6thpay 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 7thPay 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 7thPay Commission Monetary Ceiling on Gratuity was restricted toRs.10 lakh which means a government employee cant draw a Gratuity of more thanRs.10 lakh in their life time. With the changes in the 7thPay Commission, this monetary ceiling has been increased toRs.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 7thpay 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 as12 times of 'emoluments', now under 7th Pay Commission this interval is break down as under :-

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 approx 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 expressed in this article are mine and not necessary refer to my current or previous employer. The author can also be reached at rajat.actuary@gmail.com