Setting Salary Growth Rate & Withdrawal Rate Assumption Amid Covid-19
Key Stakeholders who can make use of this articles:
- Actuaries & their team: Performing Actuarial Valuations
- Stat. Auditors & their team: Vetting Actuarial Valuations
- CFO/ HR Head & their team: Setting Assumptions
- Internal Auditors & their team: Accounting & Reporting
Through this article, I am sharing my thoughts on how one can plan to make judgements on actuarial assumptions amid uncertainty as statistical evidence may just not be enough to confirm any hypothesis in a highly uncertain business environment.
Introduction & Background:
Assumptions play a pivotal role in the Actuarial Valuation of Employee Benefit liabilities like Gratuity, Privilege Leave and Pensions in an Indian Context. In this article, I am going to focus on three key assumptions used in Actuarial Valuations namely Discount rate, Salary Growth Rate and Withdrawal rate. The views may be used while vetting the actuarial reports as per AS-15 (Revised) or IND AS 19 or IAS 19. I have not considered the mortality rate assumption as most actuaries (Almost all) use or will use standard published mortality tables in the coming valuation period as this assumption only impacts pension liabilities which are offered by only public sector entities or government bodies in India. I do not expect a major deviance in the approach of actuaries at this juncture of the crisis.
General Guidelines with respect to Assumption Setting:
When setting assumptions, we should first look at the existing regulatory guidelines governing assumptions. These guidelines can be generally found in the Accounting Standards relevant to Employee Benefits. Regulatory guidelines regarding assumption setting can be prescriptive or principle based or a mix of both.
The current guidelines as laid in the AS-15 (Revised), IND AS 19 & IAS 19 relating to actuarial valuations are prescriptive for discount rate assumption and the responsibility of setting the salary growth rate and the withdrawal rate assumption is laid down on the management.
Thus, the key question at hand which I look forward to address is how we should determine the salary growth rate and the withdrawal/attrition rate in the current uncertain times, where every day a new picture unfolds and where we can only put a high or a low outcome probability on the future time periods.
Asking the Right Questions to form first hand judgement:
Generally, any assumption setting exercise in a normal business environment, gives a lot of weightage to the past trends. For example, in order to set a salary growth rate assumption, we look at average salary growth either at an aggregate level or at a function level for past few years. We use that as our audit documentation and set assumption for future years based on past guidance.
But in the current context, I would highly recommend that have a 360 degree review of all parameters should be done before going by the standard approach.
As the first step to assessing the salary growth rate and withdrawal assumption, I recommend that we ask following critical questions at the time when we vet these assumptions:
- What is the future outstanding term of the liability (Post Employment Term) for which I need to project the salary growth rate assumption?
- What is the Impact of COVID-19 at an India level over future time periods?
- Is the business of the entity going to be negatively impacted by the COVID-19? And if yes, for how long?
- Are the government measures (if taken) going to offset the short term negative trends experienced by the industry?
- What is the Top Management view with respect to salary escalations and attritions?
Devising a sound strategy amid uncertainty
PLAN A: Specific Approach
Based on the personal assessment of the above questions, view of different stakeholders, a strategy could be planned to change the assumptions or keep them unchanged. If the assumptions are to be unchanged, there is no worry.
But if the entity is planning to change the assumptions, I would highly recommend changing the assumptions systematically over a period of 2 to 3 years (in case of yearly reporting) or over 4 to 8 quarters (in case of quarterly reporting) unless we are very certain that the incoming evidence merit a full knock down.
Let me explain this. If the Management after consultation with Actuary and Auditors, sense that the average long term salary growth rate of employees will come down by 2% as a result of COVID-19, then I would advise to gradually reduce the salary growth rate assumption by 1% over next two years unless evidence strongly suggests otherwise. Same would be the case with attrition rate assumption which will be more sensitive to the event.
This is because the assumptions have a big bearing on these retirement liabilities. A 1% change in the salary growth rate can bring approximately 10% change in a liability with a post-employment term of 10 years (in case of uncapped gratuity benefit). If COVID-19 disappears in the next six months for life, we can avoid unnecessary volatility in P&L or OCI with respect to these liabilities.
PLAN B: Generic Approach
A more generic view assuming that we don’t know how things will unfold is to assume that long term salary growth rate will move more in line with discount rate changes. Thus we can look forward to reduce the salary growth rate to the tune of reduction in the discount rate from the previous reporting period. This would significantly help in reducing the volatility in the P&L and OCI with respect to Retirement Benefit Liabilities.
Please feel free to write to me at firstname.lastname@example.org or reach out to Hiral – 98677 41102 with any observations or valuable input.
Stay Safe & Stay Healthy. Let’s pray and work towards a better tomorrow from the learning that this phenomenon has brought us.
Consulting Actuary, Kapadia Actuaries & Consultants