Gratuity scheme valuation, sponsor distress and a proposed NPS switch
Zenith Technologies sponsors a funded gratuity scheme covering 14,000 employees. The trust's assets are ₹3,100 million against an Ind AS 19 defined benefit obligation of ₹4,350 million, and 78% of the assets are in equity mutual funds. The discount rate has been reduced from 7.1% to 6.6% following the fall in G-sec yields, salary escalation is assumed at 9%, and attrition is assumed at 18% for staff under 30 and 6% above 45. The company's free cash flow has halved after a large acquisition. The CFO wants to (i) raise the salary escalation assumption to 7.5%, (ii) use the expected return on plan assets to reduce the charge to profit, and (iii) close the scheme to new entrants who would instead join the National Pension System. The statutory actuarial valuation is due in six weeks, and the trustees have asked whether the funding gap is a going-concern issue.
1. Evaluate the three proposals. Which are technically defensible and which are not, and why?
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Proposal (i) - reducing salary escalation to 7.5%: not defensible on the evidence. Assumptions must reflect the employer's actual and expected increment policy, promotion patterns and inflation. Given a 9% historic basis and no evidence of a change in policy, a 1.5 point cut purely to reduce the liability is assumption-shopping. Because the gratuity benefit is salary-linked, the DBO is highly sensitive: I would expect a reduction of roughly 8–12% in the obligation, which is material and would need disclosure. If there is genuine evidence - for example a formal pay policy change - the assumption can move, with the evidence documented.
Proposal (ii) - using the expected return on assets: not permitted. Under Ind AS 19 the charge is the net interest on the net defined benefit liability, computed at the discount rate, plus current service cost. The expected return on plan assets is not an offset to the profit and loss charge; the old expected-return approach is not available. Remeasurements, including the actual return above or below the discount rate, go to other comprehensive income.
Proposal (iii) - closing to new entrants: permissible, but limited. It stops future accrual and therefore future service cost, but the existing DBO of ₹4,350 million is unchanged, and accrued benefits continue to grow with salary escalation until members leave. It reduces the future build-up, not today's gap.
2. The trustees ask whether the ₹1,250 million gap is a going-concern issue. Advise them, distinguishing accounting measurement from funding.
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The question has two answers, and the trustees should hear both.
Accounting. Ind AS 19 measures the obligation on a going-concern basis using market-consistent assumptions. The ₹1,250 million deficit (a 71% funded ratio) is a balance-sheet item; it does not by itself mean the scheme cannot pay benefits as they fall due, because gratuity benefits are paid on exit and the cash outflow is spread over many years.
Funding. Funding is a separate question, driven by the trust deed, the actuarial valuation basis and the sponsor's covenant. The sponsor's free cash flow has halved after an acquisition, which is the real risk to the trustees: the deficit must be funded by contribution, and the covenant is weaker than a year ago. The asset side compounds the problem - 78% equities against a salary-linked liability means the deficit can widen sharply in a market fall, exactly when the sponsor is least able to contribute.
Advice. The scheme is not an immediate going-concern failure, but the trustees should (a) require a schedule of contributions with a defined deficit-recovery period, (b) seek security - a parent guarantee or escrow - given the covenant deterioration, (c) adopt a de-risking policy reducing the equity weight as the funding ratio improves, and (d) receive quarterly monitoring of the funding ratio against agreed triggers. I would state the sensitivity to a 20% equity fall and a one point fall in the discount rate.
3. How would you communicate the position to the board and to members, and what would you refuse to do?
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To the board. Present the certified numbers, the assumptions with the evidence behind each, the sensitivities and a proposed contribution schedule. Show the funding ratio under a 20% equity fall (roughly a further ₹480 million of deficit on the equity holding) and under a one point discount rate fall. Explain that the accounting charge is not discretionary and that the proposals to change salary escalation and to credit the expected asset return would not be supportable.
To members. Communication must be factual and not alarmist: the scheme's benefits are defined by the trust rules and are not affected by the accounting measurement; the trust and the company are addressing the funding position; accrued benefits are secure subject to the sponsor's covenant. I would avoid giving members a personal projection I cannot stand behind.
What I would refuse. I would not sign a valuation using a salary escalation assumption I do not believe, and I would not describe the scheme as fully funded or as free of risk to the trustees. I would also decline to give the trustees an unqualified statement that the sponsor covenant is adequate without the security measures above. If the board instructed me to change an assumption without evidence, I would record my advice in the trustees' minutes and, if the certified valuation were affected, consider whether the matter should be reported further.