Discount Rate Impact June 2019 Actuarial Valuations

Introduction

The discount rate is a key assumption used in the Actuarial valuation of employee benefit liabilities. Actuarial valuation primarily finds the Present value of the liabilities (or benefits), that is expected to be paid in the future. For this purpose, it is vital to use the appropriate discount rate. The various accounting standards have prescribed, for the purpose of Employee Benefit valuations, the basis for choosing the discount rate. It states that an entity should use the government bond yields (or corporate bond yields, where applicable) for a term that is equivalent to the maturity term of the liabilities.

Because of the aforesaid Guidance, the year on year movement in the discount rate is reflected in the year on year fluctuations in the Company’s Profit and Loss and Balance sheet. Thus, it is important to understand the discount rate volatility and strategize ways to mitigate this impact.

Study of the Impact of Discount Rate

Along with the change in the inter-valuation discount rate, even the maturity term of the liability leads to the change in Liability. An approximate way to gauge this impact is given by the formula below.

Impact as a % of Liability = Approx. { Minus (Maturity Term * Change in Discount Rate) }

Let us study the impact of the change in liability due to a change in the discount rate with a simple example below.

Example:

This means that, if there was a liability of Rs. 100 as of 31st Mar 2019, and the discount rate falls from 7.35% to 7.10% in June 2019, the liability will increase by approximately 2.50%, all other things being the same.

Strategies to reduce the Discount Rate Volatility

Since we do not have any control over how the interest rate will fluctuate, we have to look at other aspects that will help us to mitigate the variations in the liability caused due to changes in the discount rate. Below are a few strategies which the company may adopt.

• Linking the salary growth to discount rate

Along with the discount rate, another assumption considered for Actuarial Valuation is the salary growth rate. As the discount rate is used to discount the Expected future outflows of the Plan Benefits, so is the salary growth rate used to project the expected salary increases and hence the expected benefit payouts. We can fairly assume that both discount rates and salary growth rates are inversely proportional to each other while estimating the Plan liabilities, except where the employee reaches a particular benefit ceiling specific to the plan (example: Limit of Rs. 20 lakhs in Gratuity benefit). Further, the discount rate serves as an important indicator of the conditions of the credit economy, and hence the future salary increases.

So if the management can fairly project the salaries for next few years and then link the salaries to the discount rate thereafter, then the impact of the discount rate can be reduced.

Example:

Both options 1 & 2 will yield the same result in the June 2019 valuations, however if the discount reduces by 1% in June 2020 to 6.10% then option 2 will have more stable profit and loss account in June 2020.

• Asset Liability Matching Strategies

Another approach of reducing the impact of the discount rate is to match the assets and liabilities. Investment in Traditional funds (example: LIC) doesn’t give cushion against discount rate volatility as the fair value of these assets will not change with the change in discount rate expectations year on year. Hence, the liabilities will increase or decrease in line with the discount rate but Traditional funds will remain unfazed by deviations in the discount rate. This leads to Asset Liability mismatch and volatility in profit and loss accounts.

Companies should plan to invest in ULIPs or other investment options which give a good asset-liability match in respect of liability profile and duration. This will help to curb the volatility resulting from discount rate variations.

For example, considering the assets are invested in instruments who give mark to market returns, in falling interest rate scenarios, employee liabilities will increase so will the asset values, thereby offsetting actuarial gains or losses on assets and liabilities, resulting in a smoother profit and loss account.

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