Actuarial Valuation of Gratuity-Sensitivity to Assumptions and Employee Profile

Introduction 

Gratuity is an important component of employee benefits, which guarantees the employee financial stability after a long period of service. Actuarial Valuation helps organizations be able to accurately determine their responsibility for this benefit. The assessment process is greatly influenced by different assumptions and the employee profile. Understanding these sensitivities is important for accurate and consistent financial planning.

Sensitivity to Actuarial Assumptions:

The Actuarial assumptions is the basis for evaluating gratuity and even small changes in these premises can lead to massive changes in liability. Below, we dive into the key assumptions and their effects, supported by observations:

• Discount Rate

Discount rate refers to the rate on which future liabilities are discounted, it is usually determined according to yields of government security. 

Impact on Liability: A lower discount rate increases the liability as the present value of the future payments increases. Conversely, a higher discount rate decreases or does not occur because of the low present value. 

Market Dependence: The discount rate is influenced by current economic conditions and government bond yields. Organizations need to adjust these assumptions in line with market trends.

Observation: Sensitivity highlights the importance of adjusting this assumption to existing market conditions.

• Attrition Rate

Attrition tax refers to the percentage of employees who are expected to leave the organization every year. This assumption determines the number of employees who will be eligible to receive a pension in the future.

Observations:

Higher attrition rates: An increase in the attrition rate usually reduces liability. This is because fewer employees are expected to meet the service eligibility criteria on an ongoing basis.

Low attrition rate: A low attrition rate increases responsibility. This assumes that more employees stay and are eligible for bonuses.

Impact: The impact of attrition rates varies depending on employee demographics and organizational policies. But it has a significant impact on long-term responsibility.

• Salary Escalation Rate

The salary escalation rate is the projected annual increase in employee salaries.

Observations:

Higher Salary Escalation Rate: An increase in this rate leads to higher liabilities because gratuity is based on the last drawn salary. For instance, a rise from 6% to 8% could substantially increase the liability.

Lower Salary Escalation Rate: A lower rate reduces the liability, as future salary growth is expected to be slower.

Impact: This assumption directly affects gratuity calculations and is particularly sensitive in organizations with high salary increments.

• Mortality Rate

Mortality Assumptions are based on standard actuarial tables such as AM92, ELT-15.

Observations:

Higher death rate: If the death rate is higher, fewer people are expected to survive the reforms and reduce liability.

Lower death rate: A lower death rate increases responsibility. Therefore, more and more employees are expected to survive and qualify for a pension.

Impact: Although the impact of death predictions is generally small compared to other factors, it is also important in organizations with a majority of older employees.

Sensitivity to Gratuity Limit 

Liability for gratuities is limited by the Gratuities Act 1972. However, many companies offer gratuity benefits that exceed this limit.

Observation:

Increasing the gratuity limit: Increasing the legal limit (for example, from ₹ 10 lacs to ₹ 20 lacs) can significantly increase liability. This is especially true for high-salaried employees.

Custom Pension Policy: Organizations that provide benefits beyond legal limits carefully analyse the financial impact.

Sensitivity to Member’s Profile

There are certain characteristics of employees of the population such as- Age, years of past service which play a critical role in determining the gratuity liabilities.

• Age

Employee age affects the time horizon for gratuity accrual and payment.

Observation:

Younger employees: Younger employees will have increased responsibilities due to increased time to salary raises and potential bonus payments.

More efficient employees: More efficient employees have reduced responsibilities because pay is closer to performance. But the amount is usually higher because the service period is longer.

Impact: Demographic sensitivities must be carefully considered during workforce planning.

• Years of Past Service

The length of service completed by an employee impacts the gratuity amount directly.

Observations:

Longer Tenure: Employees with longer service years have higher liabilities as gratuity is calculated based on completed years.

Shorter Tenure: A shorter service period results in lower liabilities.

Impact: Sensitivity to past service is significant, particularly in industries with low attrition rates.

•  Salary

The salary level of employees is directly proportional to gratuity liability.

Observations:

Higher Salary: Employees with higher salaries result in larger gratuity payments, increasing the liability.

Lower Salary: Employees with lower salaries contribute to reduced liabilities.

Impact: Salary distribution across the workforce heavily influences the overall gratuity valuation.

Key Takeaways

Discount Rate: This is the most sensitive assumption, with small changes causing significant fluctuations in liabilities.

Attrition Rate: Understanding workforce dynamics is essential for accurate estimations.

Salary Escalation Rate: High sensitivity to this rate requires careful alignment with organizational salary policies.

Mortality Rate: While less sensitive, accurate mortality assumptions ensure precision, particularly in specific demographic groups.

Gratuity Limit: Any changes to statutory or organizational gratuity limits must be closely monitored for their financial impact.

Member Profile: Employee characteristics, such as age, tenure, and salary, are critical in determining gratuity liabilities and require detailed analysis.

Frequently Asked Questions 

1: What is the attrition rate assumption?
The percentage of employees expected to leave the organization annually.

2: How does a lower attrition rate impact gratuity liability?
It increases the liability as more employees are expected to qualify for gratuity.

3: What is the salary escalation rate?
The projected annual increase in employee salaries.

4: How does increasing the gratuity limit impact liabilities?
It increases liabilities, particularly for high-salaried employees.

5: How does a higher salary escalation rate affect gratuity liability?

It increases the liability because gratuity is based on the last drawn salary.

6: How does employee age affect gratuity liability?

Younger employees increase liability due to longer time horizons, while older employees have higher immediate payouts.

7: Why are years of past service important in gratuity calculations?

Gratuity is directly proportional to the number of years an employee has worked.

8: How does a higher salary influence gratuity liability?

It increases liability as gratuity payments are based on the last drawn salary.