Introduction

A gratuity is a fundamental and statutory employee benefit given by an employer to an employee in recognition of their long-term service and contributions to the company. It is given when the employee retires, dies, leaves, or is no longer able to work. The gratuity benefit is controlled by the Payment of Gratuity Act, 1972. Funding a gratuity scheme involves ensuring that an organisation can meet its statutory obligations towards employees while maintaining the assets aligned with the liabilities. Some of the key issues which must be considered while funding a gratuity scheme:

Regulatory Compliance

In order to fund a gratuity scheme, adherence to the Payment of Gratuity Act, 1972 is required. It is one of the critical foundations for funding gratuity schemes in India. Employers also have to make sure that their funding plans align with the legal framework and accounting standards set by ICAI.

Some of the rules of Payment of Gratuity Act, 1972 are:

1. Employees are eligible for gratuity benefits after completing at least 5 years of continuous service (except in case of disability or death).
2. Employers must pay their gratuity payments within 30 days of it becoming due otherwise interest has to be paid along with penalties.
3. Employers must maintain a record for gratuity payments and file necessary returns with the tax department.
4. Employers must create a gratuity fund with the help of an approved trust (such as LIC) or it has to directly manage the payouts from organisation’s own funds.

Liquidity Planning

One of the key consideration in funding a gratuity scheme is liquidity planning, an effective liquidity planning is so essential, especially for organisations operating with lower current ratio. As gratuity liabilities are of a big amounts, particularly for companies which have large workforce, without proper planning employers may fail to pay the liability which leads to employee dissatisfaction and some legal consequences in the longer-run.

In schemes which are funded , it is liquidity planning which make sure that the gratuity trust has enough resources to pay the immediate liabilities, such as payout for employees who are no longer able to work.

So the employer has to make sure that most of the organisation’s assets have high liquidity such as government bonds, share market funds, i.e. instruments which can be easily converted into cash.

For schemes which are unfunded, employers must maintain sufficient reserves to handle gratuity payments when one has to pay them. It also involves forecasting upcoming liabilities with the help of actuarial valuation. It allows organisations to allocate resource effectively and efficiently.

Economic and Market Conditions

The Economic condition in the country plays a crucial role in gratuity scheme funding, it influences both the investment decisions (in case of funded schemes) as well as liabilities arising. There are different factors such as interest rates on government bonds, inflation, and economic growth also affects the salary escalation rate and the discount rate used for actuarial valuation is also influenced by the market conditions.

In case of high inflation rates, gratuity liabilities (future) can grow exponentially high due to rising salaries. Similarly, when there is a recession it may lead to employee attrition which can increase the immediate liabilities.

Market Conditions also effect the performance of gratuity funds (in funded schemes). If there is a decrease in interest rate then it may reduce the investment returns which can lead to higher contributions in order to match assets with liabilities.

Employers need to adopt a dynamic approach to investment strategy, the investment must be diversified across different options so that it can hedge against economic fluctuations.

Longevity Risk Management

Longevity risk means that employees living longer than expected which poses a unique challenge for organisations. Longer lifespans means that liabilities persist for a longer period which requires employer to contribute more in order to meet this liability.

In funded schemes, longevity risk may make the fund’s resources lesser than the future liabilities especially in cases where investment returns are less than the liability growth. A portfolio which is diversified may mitigate this issue.

In unfunded schemes, the risk is even high as payouts are directly tied to the employer’s current cash flows situation. Regular reviews of liability assumptions and proactive measures to fund policies can help in managing the risk effectively.

Tax Implications

Tax implications significantly influence the funding planning for gratuity schemes. As the Section 36(1)(v) of the Income Tax Act,1961 allows the contributions to an approved gratuity fund to be treated as tax-free which allows employers to reduce their taxable income. This also makes the funded schemes more attractive to organisation (with higher tax liabilities). But in order to gain benefit the organisation has to make sure that their gratuity fund is approved by the Income Tax Department.

Unfunded Schemes on the other hand, do not offer such tax advantages, as payouts are treated as operational expenses and are therefore not eligible for any kind of deductions.

Employers must also take care for employee tax considerations. For employees, gratuity payouts upto INR 20 lakhs are tax-free.

Conclusion

The decision to fund a gratuity scheme depends on a lot of other factor as well. All of this must be taken into considerations before coming to a final decision and in order to meet overall business objective. It is an essential responsibility for the employers as it requires careful consideration of financial, regulatory and workforce related factors.

By adopting a structured and a future looking strategy, organisations not only meet its regulatory compliance but will also be able to build trust among employees.

Frequently Asked Questions about Actuarial Valuation