Saudi Arabia – Part Four: COVID-19 – Impact on IFRS Assumptions
“CATASTROPHE” – a word that, until now, has commonly been used for any relative adversity, be it small or large. Phrases such as “My Dinner Party was a catastrophe” or “My High School Re-Union was a catastrophe” are not unusual in everyday conversation. However, am sure it can be agreed that the world is currently experiencing a real-life catastrophe in the form of the COVID-19 pandemic.
We all know how devastating this catastrophe has been; the “invisible enemy” or ”devilish illness”, as US ex-President Trump and UK Prime Minister Boris Johnson have respectively described it, has not only had an enormous impact on our personal lives (in insufferable and unimaginable ways) but has also vastly slowed economic activity and reduced investor sentiment around the entire world.
However, this Article (the final in the Series) is not intended to consider the global perspective; let us hone in on one country in particular that is suffering from the economic crisis; that is Saudi Arabia.
Impact of the Pandemic
The COVID-19 virus has posed unprecedent challenges to businesses, their employees and their customers. Most Boards of Directors and Management teams are under tremendous pressure to consider near-term cash management challenges and to create new and detailed business and disaster recovery plans and stress test as extensively as possible.
When it comes to the workforce, an organisation must consider multiple options, to reduce cost and increase efficiency. A significant number of companies in the KSA have already ceased recruitment and are considering re-alignment of roles, freezing of salary awards and, in extreme cases, bulk retrenchments.
As Head of Employee Benefits (“EB”) working for an Actuarial firm (“Lux Actuaries”) in the Middle East, where strict lockdowns have been in force, I have had to question how to reach Lux’s EB clients, how to work effectively in a home environment and how to help companies maintain adequate cashflow.
This Article will focus on how Lux’s clients are changing their expectations and demands in this Brave New World we live in. I’m deliberately going to shine the spotlight on Lux’s EB clients in KSA as, arguably, the Kingdom (the second largest State in the Arab world) has been one of the hardest regions impacted economically by COVID-19 (when you consider the related oil price crisis) and so, unfortunately, there are plentiful challenges to write about.
Impact on Actuarial Assumptions
COVID-19 is having (and will continue to have, at least in the short-term) an impact on almost all the IAS 19 valuation assumptions. These were discussed in Article Three of this Series – we will take each one in turn.
Both COVID-19 and reduced oil prices have caused significant volatility in Bond yields, in the KSA. In the graph below, we illustrate how yield rates have changed from 31 December 2019 to 30 June 2021.
Graph 1: Change in the KSA Government Bond Yield Rate
This scatter graph shows that, as at 31 December 2019, yield rates acted as expected by increasing with the length of the duration. However, the situation as at 31 December 2020 and 30 June 2021 is very different and demonstrates the volatility of the Bond markets at these two dates. Furthermore, for almost all durations, yields have markedly declined since 2019.
Graph 2: Discount Rate change experienced by some Companies in the KSA
Graph 2 above is based on a cross-section of Lux’s IAS 19 clients whose duration of the liabilities has not changed by any more than +/- 0.3 years between 31 December 2019 and 31 December 2020.
It can be noted from this that, for all durations, the discount rate has significantly reduced from 2019 to 2020, i.e. by at least around 20%, with some clients experiencing a far greater reduction where their duration of liabilities is below 10 years. This has had a detrimental impact on their EOSB liabilities, since the lower the discount rate is, the higher the Defined Benefit Obligation is, assuming all other variables remain constant.
Salary Escalation Rate
Due to the economic slowdown, it is likely that many companies will suspend salary increases for the foreseeable future and so not budget for any salary escalation at the end of FY 2021 and perhaps also not for the end of FY 2022. For some of Lux’s clients we have agreed to set the salary escalation assumption for FY 2021 and FY 2022 to zero, and only from FY 2023 assume that salary increases normalize again.
An inevitable consequence of these distressing times is companies having to make mass redundancies. For the FY 2020 valuation cycle, some client auditors raised the matter of “curtailment” and referenced paragraph 105 of IAS 19 which stipulates that a “curtailment occurs when an entity significantly reduces the number of employees covered by a plan”. In circumstances where it is considered to be material, this gives rise to a negative Past Service Cost, to be recognized in the P&L.
Accordingly, for the next valuation cycle, consideration should be given to any planned retrenchments that could significantly reduce headcount. To determine attrition rates as at 31 December 2021, past experience is less important than usual, given the atypical times we find ourselves in.
How Lux is Helping
Considering the crisis situation, which is continually changing and showing only minor signs of improvement, Lux foresees a material impact on the EOSB liabilities of our clients at 2021 year-end (for further details on EOSB, please refer to Article 2 of this Series).
In this time of crisis, we all have a moral and ethical duty to do what we can to help and to not take financial advantage of the situation. Lux has been mindful of this duty, incumbent on us all. One way in which we have assisted our clients, is in providing a complimentary service, by offering to conduct an impact analysis, i.e. an assessment of IAS 19 outcomes, based on different scenarios we expect in the short-term future.
The short-term changes to the assumptions (reduction in the discount rate, lower salary escalation rate and higher attrition rates) all impact on the liabilities.
Eventually, when the economy starts to recover and we benefit from more normalized conditions, actuarial companies such as Lux will need to engage with their clients and collaboratively agree to a re-setting of the assumptions to allow for the improved long-term future outlook.
In the interim, one can only hope that such shocks to the Balance Sheet can be endured and green shoots start to emerge soon.