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 Attrition Rate Retirement Age 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

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 Percent Change 97.67% 101.97% 109.87%

Date of Valuation Number of Members Salary Discontinuance Liability

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

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 5 10 15 20 25 30 35 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 95,538 100,000 91,424 100,000 87,500 100,000 83,722 100,000 80,080 100,000 76,592 100,000 73,465 91,239 83,531 76,508 70,047 64,091 58,643 54,022 87,099 76,273 66,853 58,573 51,276 44,902 39,799 83,112 69,602 58,381 48,957 41,020 34,398 29,410 79,274 63,476 50,953 40,909 32,822 26,381 21,831 75,582 57,854 44,449 34,181 26,279 20,268 16,306 72,031 52,699 38,759 28,562 21,061 15,613 12,280

Gratuity Liability
Gratuity Liability
120,000 100,000 80,000 60,000 40,000 20,000 0 5 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

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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

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