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:

• 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:-

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 approximately 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

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.

The author can also be reached at guptarajat9617@gmail.com