Saudi Arabia - Part Three: Setting Assumptions for an IAS 19 Valuation of EOSB
Companies in Saudi experienced a steep learning curve in 2018, when they became a first-time adopter of IAS 19 under IFRS.
In addition to having to understand that, going-forward, their End of Service Benefit (“EOSB”) liabilities would be computed using a different methodology from the one they were used to (as discussed in Article Two), they also needed to learn that there were certain assumptions underlying the calculation model that would need to be understood.
This penultimate article in the Saudi Series considers the range of actuarial assumptions (financial and demographic) that are prescribed under IAS 19 and how these impact on a company’s EOSB liabilities, in the context of financial reporting and accounting.
In order for an actuary to set the discount rate, the duration of the liability first needs to be computed.
For IAS 19 purposes the discount rate used is determined by reference to the 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. Currencies and terms of bond yields used must be consistent with the currency and estimated term of the post-employment benefit (duration of the liability) obligations being discounted.
In Saudi, due to the lack of liquidity and the deep market constraints of local corporate bonds, actuaries typically make reference to the KSA government bond rates when setting the discount rate.
Salary Escalation Rate
In accordance with IAS 19, the salary increment assumption is the long-term salary escalation that is expected to be awarded by a company to its employees over the complete run-off period of the liability.
For IAS 19 purposes, the setting of the salary escalation assumption is the company’s responsibility and this assumption is determined based on its HR reward policy (allowing for inflationary and promotional increase practices, supply and demand in the employment market and other economic factors), its long-term expectations and the future business plan and budget for awarding salary increases to employees.
Impact on the Liability of the Financial Assumptions
The discount rate and salary escalation rate should not be viewed in isolation. The relationship between them is more important than their individual values, i.e. the difference between the salary escalation and discount rate – the “net compounding rate”.
The future EOSB liabilities are projected in line with the salary escalation rate and discounted using the assumed discount rate.
When the salary escalation rate is lower than the discount rate then the net compounding rate is negative. This is equivalent to reducing the EOSB liability, from its current level, by the net compounding rate.
The leaving service demographic assumption (otherwise known as the attrition rate or withdrawal assumption), determines the rate at which employees are assumed to resign from service before reaching normal retirement age.
It is typical to assume the employees’ age dependent probability of leaving service, with withdrawal rates being set higher for younger employees and lower for the more mature age groups.
This demographic assumption determines the rate at which in-service employees are assumed to die.
Mortality tables that are commonly relied upon are the Permanent Assurance 2000 tables, AMC00 and AFC00, for male and female employees respectively (published by the Institute and Faculty of Actuaries (UK), based on the mortality experience for the period 1999-2002).
Of all the assumptions to consider, the mortality rate assumption has the least impact on EOSB liabilities.
In accordance with IAS 19, the actuarial assumptions must be unbiased and mutually compatible.
The principal assumptions used (financial and demographic) are the “best estimate” of the variables that will determine the ultimate cost of providing the EOSB.
Given that the future is uncertain, actual experience may well differ from the assumptions set; these differences may be significant or material. Furthermore, actuarial assumptions may change from one IFRS valuation to the next because of mandated requirements, demographic experience, changes in expectations about the future and other factors.
In the majority of cases, the actuarial results computed under IFRS are most sensitive to the Financial assumptions (discount rate and salary escalation rate); they are not much sensitive to changes in the withdrawal rate or mortality rate.
Whilst actuaries have the ability to use their discretion when considering the assumptions to set, having regard to what is reasonable and just, in the context of the region in which the post-employment benefit obligations are being discounted, they must be considered to be reasonable and a “best estimate”, based on a number of factors including the company’s payroll data, past experience, future economic outlook, regional benchmarks etc.
However, in some cases, companies wish to influence results to the extent that is permissible within IFRS and IAS 19 requirements and stipulations, in order to reduce the level of liability. Given that actuaries have a degree of flexibility, pragmatic solutions are often offered to companies to achieve this, including a re-setting of the assumptions within reasonable parameters, when historical data indicates that this is permissible, within IFRS and IAS19 stipulations.
In the final Article of this Series, we will move forward to the present day and look at how the COVID-19 crisis has affected IFRS reporting, with particular focus on IAS 19 actuarial assumption changes that have led to short-term Employee Benefit liability increases.