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Gratuity Valuation Techniques
Gratuity Valuation Techniques
PANDIT
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
Attrition Rate
Retirement Age
M/S. K.A.PANDIT
Method of Valuation
Benefit
Purpose of Valuation
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.
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
0%
1%
2%
3%
4%
5%
6%
7%
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
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).
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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.
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.
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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
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