M/S. K.A.

PANDIT

My First Gratuity Valuation

Circa September 2005, My first day of work at M/s KA Pandit. The very next day
after my fourth actuarial paper, I joined the office.
Dressed prim and propah, enjoying a bumpy rickshaw ride, the old memories of
the early days of my beginning a career in actuarial science came back rushing
to me. Then the course seemed to me so unfathomable (it still does!) that I
thought GOD MUST HAVE BEEN AN ACTUARY. From early reasons behind
this notion like the course size being gargantuan slowly some more similarities
occurred to me. One of the first that came to my mind was that of a love for the
law of large numbers God revels in the faith and love of large populations while
an actuary relies heavily on large populations for so many things like the concept
of insurance or instance or for that matter even the radix used for mortality rates
for deciding the credibility of data etc. Another thing that warrants attention is the
fixation for precision look at everything around and you see precision in Gods
actions. There was nothing, no space and not even time almost 12 billion years
ago. God the creator created tremendous energy out of nothing with a single
incident called the big bang and the universe was created (Stephen Hawkins in
A Brief History of Time). A slight deviation, a fraction less or more, a jiffy here or
there would have resulted into destruction of the universe before its creation.
Since then our universe is expanding. A similar inclination towards precision can
be attributed to an actuary in more ways than one.
My retrospection ended when the burly rickshaw driver asked me for directions
which brought me to REMIBIZ COURT. A dishy restaurant at the entrance
seemed to me a good omen. An interesting looking black marble fountain
welcomed me (I wasnt expecting a Victorian masterpiece, was I?). A short
elevator ride later I walked into my office, a place where I would be spending a
third of my day for many days to come. A nice, cozy, well-lit place, transparent
partitions (goes to say a lot about the employers). I loved it already.
Bismillah I said, may God bless my work. I was introduced to the staff and
shown to my work station. Let me introduce to you at this point Ms.Anubha, my
colleague who also studied with me during our Actuarial Diploma Last year, and
our senior, a partner at M/s. K.A.Pandit , Mr. Akshay Pandit.
Anubha called out to me and said that she had a valuation to do and asked me to
join in.
The mail in her inbox read:
Hi, as per our telecon today please find attached the employee data for the
Actuarial Valuation of the Gratuity Liability as on 31.03.2006.
WOWWW. A gratuity valuation, but hello lady, What is Gratuity???

M/S. K.A.PANDIT
I had heard something about it being an employee benefit, could relate it to a
post retirement kind, but the billion dollar question here was that me, the ignorant
was supposed to assist in the valuation the Gratuity Liability to the employees of
a certain company.
I casually mentioned (not betraying my ignorance) that I needed to know the
actual definition of what gratuity was and heres what followed and what was to
become my forte.
Santosh : Hey Anubha how is Gratuity defined?
Anubha: I will tell you shortly about what Gratuity is about, meanwhile just
glance through these couple of pages, I will be right back.
With that pretty I will be back she handed over a couple of hundred pages (how
women love exaggerating!). I could make some sense of the ten page booklet
that was handed over to me and following are a few points which drew my
attention.
Gratuity is a post retirement employee benefit paid in lump sum on exit.
Gratuity Act (1972) makes it mandatory to pay this benefit for any
organization employing more than 9 employees.
One should be in service in company for more than 5 years to be eligible
for this benefit.
Accounting Standard makes it mandatory to reflect Gratuity liability in their
books of accounts.
Employer may provide this Liability in books, fund it or enter into an
agreement with an Insurer.
Funding is not allowed for Directors holding more than 5% of the company
shares.
The investment pattern is as prescribed by the income tax rules.
Restriction on Contributions to Fund
I grasped the fundamentals and proceeded to grill Anubha with a volley of
questions.
Santosh : Then, am I correct if I say that if an employee who has served the
company for the last 6 years is entitled to three months of salary as gratuity?
Anubha : Yes almost three months, since month is considered to be of 26
working days (barring 4 Sundays) divisor for gratuity is considered as 15/26
instead 15/30. This will benefit employees a little by having a little more than 3
months gratuity. My favorite definition is Gratuity is payable at the rate of (15/26)
per year of service on salary at exit.
Anubha: Before we start working, we must always look at the last valuation of
that company.
Santosh: Why do you need that file?

M/S. K.A.PANDIT
Anubha : In the file we will get details of their gratuity scheme, last valuation
report, methodology of working etc.
Santosh : You said just now that benefits are 15 days salary per year of service,
then why you need to read that again?
Anubha : Few companies pay a benefit that varies from the Act. Lets ask Akshay.
Akshay : Hi Santosh, I understand you are getting involved in a valuation on your
very first day.
Santosh : Yes, I am.
Anubha : She wants to know why we are looking at companys last valuation
report.
Akshay: We have to look at the last valuation report to find out what assumptions
we have made. What is the method of valuation? What actuarial assumptions
have we taken? What is the purpose of the valuation? Also we can check if there
is any inconsistency in the given data.
Santosh : What are Actuarial Assumptions? Do we use the same assumptions
for all valuations and all companies?
Akshay : Actuarial assumptions are assumptions used to determine a value of
Gratuity Obligation. The main assumptions affecting the value of the Obligation
are Discounting Rate , Future Salary rise, Mortality and Turnover Rates. These
parameters play an important role in the valuation. They decide the quantum of
the Gratuity obligation. Not all assumptions are same for all companies; there
are many parameters which will affect the selection of assumptions.
Santosh : How do we determine these assumptions for a valuation?
Akshay : For the financial assumptions like Future Salary rise, we depend on
companies to give us an idea of their expectation of long term salary progression,
for rate of discounting we look at the long term rate of interest on long term
Government securities. For Demographic assumptions like withdrawal, we look
at the companys experience, if there is no sufficient experience available with
the company we may use standard withdrawal table from our database related to
industry experience. For Mortality we have published standard tables.
Assumptions may also depend upon the purpose of valuation. Apart from this
Actuarial Society of India has also issued Guidance Notes which also help us in
selection of assumptions and method of valuation.
Anubha : I have a question here, you have mentioned that long term Interest
Rate will influence selection of Discount Rate. Does that mean we are talking of
Funded Schemes only? As far as I understand, many schemes are funded with

M/S. K.A.PANDIT
Insurance companies, having returns very different from privately managed funds
last year, and many schemes are not funded.
Akshay : We do not take discount rate based on actual earnings of fund, as you
know that gratuity obligation arises on an average after 20 to 30 years depending
on the company. Keeping in mind the term of the liability and the returns the
asset would produce we use the rate available on long term security which
matches the future term of the liability.
We got back to our work desk, there were many ideas floating in my mind still,
but things started getting clearer.
Santosh: Once we calculate the liability do we just tell the company over the
phone or send them the figures by email?
Anubha: No we send them a report.
Santosh: And why is that?
Anubha: One of the main purpose companies get valuation done, is Requirement
by Accounting Standard 15 to reflect liability into books. For the purpose of that
companies depend on Actuaries to certify the amount of Obligation.
Santosh: May I have a look at last years report?
As I was reading through, a table at the end of the report drew my attention
which looks like a summary of the data
Name of Company
Date of Valuation
Number of Members
Salary
Discontinuance Liability
Projected Benefit Obligation
Average Salary
Average Age
Average Past Service
Rate of Discounting
Rate of Future Salary Rise
Mortality Table

ABC Paints Limited

31.03.2005
43
222,304
1,645,879
1,164,711
5,169.86
40.02
12.71
7.00%
5.00%
LIC (1994-96) Ult
1% for age <= 35 and 0.5%
thereafter
60 Years

Attrition Rate
Retirement Age

M/S. K.A.PANDIT
Method of Valuation
Benefit
Purpose of Valuation

Projected Unit Credit Method

15 days per year of service without
any monetary ceiling
Provision in the Books

Anubha: This is a summary of the valuation.

Santosh: Under benefit why dont we just mention as per the Act?
Anubha : The Gratuity Act 1972, says that benefits should be 15 days salary per
year of service with a maximum of Rs.350,000. This is the minimum an
employer has to pay, an employer may pay more than this if he wishes so.
Santosh: There are so many confusing terms here. Tell me, what do you mean
by Discontinuance liability and Projected benefit Obligation?
Anubha: The Liability on discontinuance basis is the amount that company has to
pay to its employees if the company closes on the valuation date. Projected
Benefit Obligation is the liability on a going concern basis. It is the amount the
company has to pay to its employees as and when they leave the company.
Santosh : Projected Unit Credit Method, what is that?
Anubha: There are different methods to value the liability, one of them is
Projected Unit Credit Method, it is one of the most popular methods in use and
also suggested by most Accounting Standards as it gives a true and fair value of
the liability. The other methods are Current Unit Method, Aggregate Method etc.
but for the time being we will concentrate only on the Projected Unit Credit
Method (PUM). This method calculates the present value of past service liability
based on projected future earnings at exit. In other words, gratuity is calculated
based on the salary at the time of exit. For calculating the past service liability,
we have to look at the future growth in salaries, rate of discounting, and all types
of decrements e.g. Mortality, Early Withdrawal etc.
Santosh: I have a couple of questions here? Do we use multiple decrement
tables for Attrition rate and Mortality? If you say we project the salary at exit,
then why is the discontinuance liability higher than calculated on Projected
earnings.

M/S. K.A.PANDIT
Anubha : The answer to your first question is yes, as this company is small and
we do not have sufficient information, we will use attrition rate from our database,
and for Mortality in service we will use LIC (1994-96) Ultimate table. For your
second question lets get back to Akshay.
Anubha : Can you elaborate on why the Value of Obligation calculated using
PUM is lower than discontinuance liability.
Akshay : When we use Projected Unit Credit Method, we find the Present Value
of Past Service liability on Projected Earnings. In this case you have noticed that
expected future salary rise is 5% and Rate of discounting is 7%. That means we
not only project the salary, we discount future liabilities to bring it back to Present
Value. In this case we are roughly discounting Liability by 2% for an average of
around 20 years. You will notice when you will do more valuations that, the
higher the net discount rate the lower the liability.
Santosh : OK , so it is the effect of net discounting always?
Akshay : Not always, but in this case yes, as the effect of attrition rate is not
much due to lower attrition.
We started working on the data. After a brief overview of the data, we found out
the minimum, maximum and average of the age, the past service and the salary.
Anubha: This will help us to check for a missing Date of Birth, Date of Joining ,
unusual salary etc. The minimum and maximum are checks, Santosh, we use
them to find any major errors or deviations in the data. Once we have verified
that the data is in order we start the valuation. We use a program where we need
to input the type of company (which determines the withdrawal rates and
company structure), salary rise, discounting rate and the retirement age
according to the rules of the scheme. This program generates factors that are
age related and which can then be used to determine the individual liabilities that
add up to the total liability for a company.
We started on valuation system, and after a while we had a summary showing
valuation results.

Summary ABC Paints Limited

Date of Valuation
Number of Members
Salary
Discontinuance Liability

31.03.2006 31.03.2005
42
43
226,685
222304
1,808,392
1645879

Percent
Change
97.67%
101.97%
109.87%

M/S. K.A.PANDIT
Projected Benefit
Obligation
Average Salary
Average Age
Average past Service
Rate of Discounting
Rate of Future Salary Rise
Mortality Table

Attrition Rate
Retirement Age

1,292,137
5,397.26
40.71
13.70
7.00%
5.00%
LIC (199496) Ult
1% for age
<= 35 and
0.5%
thereafter
60 Years

1164711
5169.86
40.02
12.71
7.00%
5.00%
LIC (199496) Ult
1% for age
<= 35 and
0.5%
thereafter
60 Years

110.94%
104.39%
101.73%
107.82%

Anubha : Here the Projected Benefit Obligation is the Value we will be certifying.
Santosh: Is that all?
Anubha: No, another very important step in this valuation exercise is comparison.
It is necessary to compare this years figures with that of the last years. We
would normally expect it to grow consistently.
Santosh: Is it because the salaries grow?
Anubha: That and also the ages (mortality increases with the age) the past
service goes up too and also the payment has to be made one period sooner.
Santosh: Now I see the reason for finding out the average ages, and the average
past service too.
Akshay: So I see the summary is ready. Want to make an analysis together? Did
you notice that Anubha has even found out the percentage increase in the
various values? These are important rates.
Santosh: The number of people has gone down by just one while the salary has
moved up by about 2 %.
Akshay: Salary increase alone is not important. It is the average salary that
shows a clearer picture.
Santosh: Did we not assume a 5% salary rise while the average salary rise here
is 4.4%. This shows a growth lower than our assumptions.

M/S. K.A.PANDIT
Akshay: Our assumptions are long term and we do expect such short term
variations. The actual may differ from the expected. Take for example Software
companies, which are generally more inconsistent and a lot of volatility creeps in
due to high attrition rates.
Santosh: Is there something like a plateau period where the attrition rates slow
down bringing about consistency?
Akshay: That is generally the case with matured companies like this one where
the average past service is high.
Santosh: The discontinuance liability is going up by about 10% as also the
Gratuity liability which moves at around a similar rate.
Akshay: Yes thats a good observation.
Santosh: And the average age and average past service what do these indicate?
Akshay: A drop in the average age and average past service would indicate new
recruitments at younger ages. If the number goes up without much change in the
past service and age then there is generally an indication of a transfer of
employees. This company has more or less consistent growths in both. Also
notice that the past service and age is relatively high, again proving that it is a
matured company we are dealing with here.
Santosh: Wow, this is getting more exciting by the minute Its becoming more
like astrology. We can know so much about the company through the data
summary.
Akshay: Its always a pleasure to see such thrill on a trainees face. You remind
me of my early days when doing my first valuation felt like unraveling a mystery.
Santosh: May I ask some more questions?
Akshay: Sure go ahead.
Santosh: Can the assumptions once decided upon be changed?
Akshay: Yes, as experience changes.
Santosh: What if the retirement age was 58 yrs?
Akshay: Here the Gratuity payment would come closer and hence naturally the
liability would be higher, all other assumptions remaining the same.
Santosh: Oh yes. May be Im getting a hang of it.

M/S. K.A.PANDIT

Anubha: Lets take a discontinuance liability of Rs.100,000 and find out what the
obligation would be considering various net valuation rates (difference between
rate of discounting and salary escalation) and average future service.

M/S. K.A.PANDIT

Net Valuation Rate: Value of Past Service Obligation is Rs.100,000

Avg. FS

0%

1%

2%

3%

4%

5%

6%

7%

100,000 100,000 100,000 100,000 100,000 100,000 100,000 100,000

100,000 95,538

91,239

87,099

83,112

79,274

75,582

72,031

10

100,000 91,424

83,531

76,273

69,602

63,476

57,854

52,699

15

100,000 87,500

76,508

66,853

58,381

50,953

44,449

38,759

20

100,000 83,722

70,047

58,573

48,957

40,909

34,181

28,562

25

100,000 80,080

64,091

51,276

41,020

32,822

26,279

21,061

30

100,000 76,592

58,643

44,902

34,398

26,381

20,268

15,613

35

100,000 73,465

54,022

39,799

29,410

21,831

16,306

12,280

Gratuity Liability

Gratuity Liability
120,000
100,000
80,000
60,000
40,000
20,000
0

10

15

20

25

30

35

Avg. Future Service

0%

1%

2%

3%

4%

5%

6%

7%

*Higher the future service lower is the present value of the obligation.
*Higher the net valuation rate lower is the present value of the obligation.
*The first cell with minimum future service and minimum net rate has the highest
value while the last cell with the maximum future service and maximum net rate
has the lowest value.(Annexure at the end shows discounting factors between
ages 20-60).
10

M/S. K.A.PANDIT

Santosh: And just one last question, you mentioned something about attrition
rates being high for software companies. Could you tell me how that affects the
Obligation?
At this point Anubha miraculously produced another table as if she knew what
was coming next and I was getting seriously embarrassed by my constant
questioning.

Name of the Company

Company A
Company A
Company A
Company A
Date of Valuation
31/03/2006
31/03/2006
31/03/2006
31/03/2006
Number
427
427
427
427
Monthly Salary
3,625,005
3,625,005
3,625,005
3,625,005
Discontinuance Liability
4,753,723
4,753,723
4,753,723
4,753,723
Past Service Liability
1,509,404
1,942,904
1,870,221
2,423,890
Rate of Discounting
7.00%
7.00%
7.00%
7.00%
Salary Escalation
3.00%
3.00%
4.00%
4.00%
Average Salary
8,489.47
8,489.47
8,489.47
8,489.47
Average Age
28.83
28.83
28.83
28.83
Average Past Service
1.78
1.78
1.78
1.78
Mortality
LIC(1994-96) ULT LIC(1994-96) ULT
LIC(1994-96) ULT LIC(1994-96) ULT
Attrition Rate
Service Related Rates
Age Related Service Related Rates
Age Related
Vesting Period
5 years
5 years
5 years
5 years

But the curious me wasnt yet done with the downpour of my questioning and
here I bounced one more:
Santosh: Ok so now tell me what if the salaries dont move as per the
assumptions or the number of people go up the next year or for that matter some
people retire before the retirement age?
Akshay: This will cause the liability to move differently than what we expect and
will lead to what is known as an actuarial loss/gain, which is better understood
now since the AS15 has been revised. This concept will become clearer to you
when you do more such valuations.
Anubha: Let me summarize for you what goes into an actuarial valuation of a
companys Gratuity liability.

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M/S. K.A.PANDIT
Firstly Assumptions: Once the data come in we must check up the date of
valuation, last years report and determine the assumptions used last year with
respect to retirement age, rates of interest, salary escalation, and any peculiarity
about the Gratuity scheme.
Secondly data: Now a quick look at the data should enable us to know whether
employee salaries, the dates of birth and dates of joining are in order.
Now for the valuation: We input the details of the assumptions in the ready made
program that gives us age related factors which can then be applied to the
discontinuance liability worked out according to the scheme of the company. This
will give us the Actuarial value of the gratuity following which average, minimum
and maximum age, past service and salary should be found out as check points.
Lastly Comparison: Any peculiar rate of change against the last years figures
should be commented upon.
Santosh: Phew! An information overload With some assistance now, I think I
too should be able to do a valuation all by myself. Thank you so much Anubha
and Akshay. This was a crash course in Gratuity (or Tarot card reading!).
With this I was left for some more retrospection and I turned to my favorite topic:
The mission of establishing Gods profession. This conversation had made my
already deep seated belief that God must have been an Actuary even stronger
now. Another case in point is that finally, when things dont happen as per our
expectations we blame it on Destiny just like actuarial losses and gains take the
blame when actuarial assumptions are not realised.

Paper is jointly written by

Ms. Santosh Charan (Actuarial Assistant)

Ms. Anubha Roy (Actuarial Assistant)
Mr. Akshay Pandit (Partner)
At M/S. K.A.PANDIT (Consultants and Actuaries)

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M/S. K.A.PANDIT

Past Service Factors at Different Future Salary Escalation and Rate of Discounting 7%
AGE SE 6%
SE 5%
SE 4%
SE 3%
SE 2%
SE 1%
SE 0%
20 0.70931 0.50556 0.36294 0.26317 0.19340 0.14455 0.11030
21 0.71382 0.51148 0.36861 0.26783 0.19677 0.14666 0.11127
22 0.71863 0.51792 0.37497 0.27326 0.20096 0.14956 0.11299
23 0.72374 0.52491 0.38204 0.27951 0.20600 0.15331 0.11554
24 0.72908 0.53234 0.38971 0.28645 0.21177 0.15779 0.11879
25 0.73465 0.54022 0.39799 0.29410 0.21831 0.16306 0.12280
26 0.74046 0.54856 0.40690 0.30250 0.22565 0.16914 0.12761
27 0.74652 0.55739 0.41651 0.31174 0.23392 0.17619 0.13338
28 0.75281 0.56668 0.42677 0.32177 0.24307 0.18416 0.14009
29 0.75929 0.57639 0.43764 0.33255 0.25307 0.19303 0.14771
30 0.76592 0.58643 0.44902 0.34398 0.26381 0.20268 0.15613
31 0.77270 0.59680 0.46091 0.35607 0.27531 0.21317 0.16542
32 0.77960 0.60748 0.47327 0.36878 0.28754 0.22446 0.17554
33 0.78659 0.61840 0.48605 0.38205 0.30045 0.23650 0.18644
34 0.79365 0.62953 0.49919 0.39583 0.31398 0.24924 0.19809
35 0.80080 0.64091 0.51276 0.41020 0.32822 0.26279 0.21061
36 0.80799 0.65246 0.52666 0.42504 0.34307 0.27703 0.22389
37 0.81523 0.66419 0.54089 0.44038 0.35855 0.29202 0.23798
38 0.82251 0.67610 0.55548 0.45624 0.37470 0.30778 0.25292
39 0.82984 0.68819 0.57042 0.47263 0.39153 0.32436 0.26878
40 0.83722 0.70047 0.58573 0.48957 0.40909 0.34181 0.28562
41 0.84466 0.71296 0.60145 0.50713 0.42745 0.36022 0.30356
42 0.85215 0.72565 0.61755 0.52528 0.44661 0.37961 0.32261
43 0.85971 0.73858 0.63412 0.54412 0.46668 0.40011 0.34295
44 0.86733 0.75173 0.65112 0.56364 0.48766 0.42173 0.36460
45 0.87500 0.76508 0.66853 0.58381 0.50953 0.44449 0.38759
46 0.88272 0.77865 0.68640 0.60469 0.53240 0.46850 0.41207
47 0.89051 0.79246 0.70474 0.62633 0.55631 0.49383 0.43814
48 0.89836 0.80651 0.72357 0.64875 0.58131 0.52057 0.46592
49 0.90627 0.82079 0.74289 0.67197 0.60744 0.54877 0.49548
50 0.91424 0.83531 0.76273 0.69602 0.63476 0.57854 0.52699
51 0.92229 0.85011 0.78311 0.72097 0.66337 0.61001 0.56061
52 0.93042 0.86519 0.80409 0.74689 0.69337 0.64331 0.59654
53 0.93863 0.88058 0.82570 0.77383 0.72484 0.67859 0.63496
54 0.94695 0.89631 0.84798 0.80188 0.75792 0.71603 0.67613
55 0.95538 0.91239 0.87099 0.83112 0.79274 0.75582 0.72031
56 0.96394 0.92888 0.89478 0.86165 0.82945 0.79818 0.76780
57 0.97266 0.94582 0.91948 0.89364 0.86829 0.84343 0.81905
58 0.98155 0.96327 0.94517 0.92723 0.90947 0.89188 0.87446
59 0.99065 0.98131 0.97196 0.96262 0.95327 0.94393 0.93458
60 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000 1.00000

* SE = Future Salary Escalation

13