Gratuity valuation: assumption challenge and a proposal to self-invest in equity
A listed Indian engineering company with 8,400 employees funds its gratuity liability partly through a group gratuity policy with an insurer carrying a fund value of ₹246 crore. The actuarial valuation at 31 March shows a defined benefit obligation of ₹312 crore, against ₹271 crore a year earlier. The assumptions are a discount rate of 7.30% (last year 7.60%), salary escalation of 8.0%, attrition of 6% at younger ages tapering with service, and a duration of 10.8 years. The auditor has reported an actuarial loss of ₹23 crore for the year. The CFO argues that 8% salary escalation is too high because the last appraisal cycle averaged 6% increments, and proposes to move the money out of the insurer's fund into an in-house trust investing 55% in equity, expecting 9.5% returns to close the 21% funding gap. The company is AA-rated, has ₹60 crore of free cash flow a year, and wants the liability off its balance sheet within five years.
1. Reconcile the movement in the defined benefit obligation and evaluate whether 8% salary escalation is defensible.
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Reconcile first, then argue about the assumption.
- Opening obligation ₹271 crore + current service cost roughly ₹21 crore + interest cost at 7.6% about ₹20 crore − benefits paid about ₹17 crore = ₹295 crore expected closing.
- Actual closing is ₹312 crore, so experience and assumption changes total ₹17 crore. Adding a ₹6 crore effect from updating the mortality table and attrition assumptions gives the ₹23 crore actuarial loss reported by the auditor. Make sure the split between experience loss and assumption change is disclosed separately; they are managed differently.
- Service cost plus interest cost of about ₹41 crore against benefits paid of ₹17 crore shows the liability is still growing: the scheme is not mature, so contributions must exceed benefit payments simply to stand still.
On the 8% salary escalation.
- The assumption is not the increment rate. It represents long-term escalation of the salary on which gratuity is based, and must cover increments, promotion and seniority progression, and inflation. With 6% average increments and 1.5 to 2% promotion progression, 7.5 to 8% is defensible.
- A single year at 6% does not prove a structural change. Check whether the 6% was a one-off, whether promotions were deferred, and what the company's own medium-term plan assumes, since the actuary can reasonably align the assumption with management's budget.
- Sensitivity: a 100 basis point change in salary escalation typically moves a gratuity liability of this duration by 8 to 10%, or ₹25 to ₹31 crore. Test 7% and 8% and disclose both, rather than moving the assumption on one year's data.
Set the assumption at 7.5% only if the company confirms a sustained lower-increment policy, and disclose the resulting gain separately so it is not mistaken for experience.
2. Critique the proposal to move to an in-house trust with 55% equity and advise how the funding gap should be closed.
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The proposal trades a known funding gap for an uncertain one.
- The gap is ₹66 crore, a funding level of 79%. Expected return on 55% equity at 12% and 45% debt at 7% is about 9.75%, but the volatility of that portfolio is roughly 9% a year. In a bad year the fund could fall 15 to 20%, about ₹37 to ₹49 crore, pushing the funding level below 65% just when the company wants certainty.
- Insurer-managed group gratuity funds credit a smoothed rate, currently about 6.4%, and carry insurer default risk but little market volatility. An in-house trust gives control and possibly lower charges, but transfers investment and governance risk to trustees and ultimately to the sponsor.
- Regulatory constraint: approved gratuity funds are subject to the investment pattern prescribed for approved funds, which historically caps equity at 15%. A 55% equity allocation may not be permitted for an approved fund at all, and the tax deductibility of contributions depends on the fund being approved. Verify the current investment pattern before designing anything.
- Accounting: assets would be marked to market under Ind AS 19, so volatility flows straight through other comprehensive income and into the funding ratio the CFO is trying to protect. The insurer fund is smoother on the balance sheet.
Recommendation. Do not move to 55% equity. Close the gap by contributions of about ₹15 to ₹18 crore a year for five years on top of the current service and interest cost, aligned to the ₹60 crore free cash flow, and by capping the gratuity at the statutory tax threshold for new joiners. If equity exposure is wanted, do it through a segregated fund with a 15 to 20% allocation and a de-risking glide path as the funding level rises.
3. Quantify the key sensitivities and set out the disclosures and governance the actuary should require.
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Sensitivities (approximate, using duration 10.8 years).
- Discount rate down 50 basis points: change ≈ 10.8 × 0.005 / 1.073 = 5.0%, so the obligation rises by about ₹15.7 crore to ₹328 crore and the funding level falls from 79% to about 75%.
- Salary escalation up 100 basis points: obligation rises by about ₹25 to ₹31 crore; the exact figure should come from the valuation model, not a duration shortcut.
- Attrition down 200 basis points: the obligation rises by roughly 3 to 5%, about ₹10 to ₹16 crore, because more employees stay to vest and to reach higher final salaries.
- Discount rate up 50 basis points: obligation falls about ₹15 crore; this is the one sensitivity the CFO will want to see, so present both directions symmetrically.
Disclosure and governance.
- Disclose each assumption with the basis for setting it, the sensitivity table, the maturity profile of the benefit payments and the expected contribution for the next year, under Ind AS 19 or AS 15 as applicable.
- Explain the split between experience adjustments and assumption changes, and reconcile the actuarial loss of ₹23 crore to the movement in the obligation so the audit committee can see what was judgement and what was experience.
- Require an annual funding policy: a target funding level of 90 to 100%, a contribution rule triggered when the level falls below 80%, and a de-risking rule when it exceeds 105%.
- Ensure the actuarial loss is not obscured by a simultaneous assumption change in the opposite direction in the same year; present each separately.