Short term gain, long term pain

14th Dec 2022, By Susan Turner

Short term gain, long term pain

The current global economic and geopolitical turmoil has not been experienced for decades and shows no signs of abating, with the cost-of-living crisis, high inflation, aggressive monetary tightening, the continued conflict in Ukraine, and the lingering COVID-19 pandemic all weighing heavily on the financial outlook. In this blog post we consider the current financial situation in the context of Employee Benefit (“EB”) liabilities, such as End of Service Gratuity Benefits (“EOSGB”), focusing on one of the most fundamental factors that determines EB liabilities: the discount rate.

 

Rising interest rates result in lower EB liabilities

The discount rate is one of the key assumptions used to compute the present value of the liabilities (or benefits) on an actuarial basis (as prescribed by IAS 19 and other accounting standards). In accordance with IAS 19, the discount rate should be determined by reference to market yields at the end of the reporting period on high quality Corporate Bonds or, where there is no deep market in such bonds, by reference to market yields on Government Bonds. Government Bond yields are extremely high right now, as a result of rising interest rates. Consequently, discount rates (which serve as an important indicator of the conditions of the credit economy) have also increased.

When discount rates increase, the EB liability reduces, if all other assumptions remain unchanged. Whilst this has a positive impact on companies’ bottom lines, Finance Directors will be concerned that the short-term hike in the discount rate will cause the EB liabilities to be underestimated in the long term; in other words, there is a risk of under-provision.

So, consideration needs to be given to the preventative measures that can be taken to avoid a shock to the Balance Sheet when the markets start to normalize. Since we do not have any control over how interest rates will fluctuate, we have to look at other aspects that will help to mitigate the variations in the liability caused by changes in the discount rate.

 

Salary esclation rates increasing due to inflation

In order to determine what risk mitigation action should be implemented, it is important to understand the other key actuarial assumptions, in particular the salary escalation rate. As the discount rate is used to discount the expected future outflows of Employee Benefits, so is the salary growth rate used to project the expected salary increases and hence the expected benefit pay-outs. This assumption changes in the same direction as the liability. So, when the salary escalation rate increases, so does the liability and vice versa.

Lux has identified that, from the start of this year, there has been a growing trend for companies to increase their employees’ salaries in recognition of the high inflation environment. For example, in Saudi Arabia, we are seeing rates increase, from the previous regional benchmark of around 2 – 3% pa, to escalation rates in excess of 4% pa. If we assume a higher salary escalation rate in 2022, when compared to 2021, then this partly offsets the increase in the discount rate, therefore suppressing the reduction in the EB liabilities.

 

Funding liabilities with matching assets

Another approach or strategy, to help reduce the impact of higher discount rates, is to match the assets and liabilities. Alternative investment options, which give a good asset-liability match in respect of liability profile and duration, will help to curb the volatility resulting from discount rate variations.

For example, if we assume that the assets are invested in instruments which give mark-to-market returns, in rising interest rate scenarios, both EB liabilities and asset values will decrease, thereby offsetting actuarial gains or losses on assets and liabilities, resulting in a smoother Profit & Loss account.

So, there is no better time than right now, for companies to seriously consider funding their EB liabilities. As a professional actuarial firm that cares about its clients’ financial stability, we recommend that such mitigation options be considered for this year’s EB actuarial valuation.

If you are interested in receiving actuarial support & advice regarding your company’s own EB liabilities, then please contact us; Lux would be delighted to assist you.

 

Related Links:

Subscribe to our newsletter

To receive your quarterly updates.

By completing this form you are opting into emails from Lux Actuaries. You can unsubscribe at any time.

© 2023 All rights reserved.

Privacy Policy