II - Provisions: Specific points and Examples

2. Employee Benefits

Actuarial Valuation

Funding versus Accounting

• Funding
  • Determines employer cash contribution to plan (contribution to plan assets for funded plans and direct benefit payments for unfunded plans)
  • Often governed by tax and employment legislation
  • Cash contribution recognized in cash flow statement
• Accounting
  • Charge (Income) recorded as expense in P&L:
    • benefit expense recognized as service accrued
    • not recognized when paid
  • and Net liability recognized in the balance sheet, which reflects cumulative difference between expense and cash contribution.

Actuarial Valuation: Types and Purposes 

Why do companies spend a lot of time on assumption setting?

• Small changes in some assumptions have a big impact on the P&L, funded status and/or balance sheet
• To ensure consistency across plans/countries
• To ensure compliance with IAS 19 requirements
• Increasing scrutiny by auditors and regulators
• Increasing disclosure requirements --> need to be able to justify assumptions to analysts/investors

Actuarial assumptions

• IAS 19 requires financial and other assumptions to be determined at each year-end, by reference to market conditions and company expectations on that date
• Actuarial assumptions should be unbiased and mutually compatible
• They are the company’s best estimates of the variables that will determine the ultimate cost of providing employee benefits
• Under IAS 19, actuarial assumption setting is ultimately the responsibility of the company
• The main actuarial assumptions are:
  • Financial assumptions:
    • Inflation
    • Social security ceiling increases, or legal pension increases
    • Salary increases
      • Expected long-term average annual rate of pay increase
      • Inflation + Productivity + Merit & Promotion
      • Increase (decrease) in salary increase = Higher (lower) DBO
      • Increase of pensions in payment (if applicable)
      • Discount rate (selected depending on the type/purpose of the actuarial valuation)
        • Time value of money
        • Must reflect current rates of return on high quality fixed on income investments
          • Bonds with AA or higher rating
          • Duration matching timing of benefit payments
          • Increase (decrease) in discount rate = Lower (higher) DBO
  • Demographic assumptions:
    • Mortality
    • Turnover
    • Disability
    • Retirement age