Introduction
For better handling of funds, companies need to correctly estimate their future liabilities. One key feature based on which their future liabilities rely upon is the employment benefit schemes such as pensions, gratuity, leave encashment, etc. provided by the company to its present as well as retired employees for their services rendered. Organizations need to accurately evaluate such future liabilities, failure to which would result in financial distress, making the company suffer in the long run.
What are Actuarial Valuation Assumptions?
Now, for precise assessment of future obligations, companies need to assess and consider various actuarial valuation assumptions. Actuarial assumptions refer to estimating the key indicators required for calculating workplace benefit plans. They involve the use of statistical techniques to estimate the occurrence of an event in future. These assumptions are crucial, any imbalance in estimating them would affect the financial stability of the company, leading to either overestimation or underestimation of required funds. These assumptions help the company to make plans for the future based on present scenarios and future predictions. Some of the key actuarial assumptions include discount rate, salary escalation rate, employee turnover rate, leave encashment assumptions, mortality assumptions, etc.
Let’s understand these key assumptions in detail.
Key Actuarial Valuation Assumptions
Estimating discount rate is one of the chief assumptions as it calculates the present value of benefits payable to employees in the future. Now, companies should choose the rate of discount very diligently as a little change in the discount rate may have great impact on the present value of benefits, and hence on the funds of the company. Keeping the discount rate too high would lead to underestimation of funds as this would mean lower present value of future obligations. On the other hand, low discount rates that are irrelevant according to the current circumstances would lead to higher present value of benefits and hence overestimation of resources. Thus, while deciding the discount rates, companies must consider not only the prevailing situation but also future circumstances that are likely to exist for better estimation.
This refers to making an estimation of the growth in the salary of employees in the near future and basing our estimates to determine the funds required to fulfill future obligations. There is a positive relation between discount rates and salary escalation rates since the increase in both of them is dependent upon the inflation likely to arise in the economy in future. Also, salary escalation rate should be determined on the basis of past as well as present circumstances, company’s long-term goals should not be missed while estimating these.
Employee turnover rate is another crucial assumption which makes the company aware about how many people are likely to stay in the company and how many would leave without claiming full benefits. More number of people staying back means lower employee turnover rate, and hence more funds required to fulfill the claims made by them in the long term. On the other hand, high turnover rate means less people are likely to claim full benefits, reducing the liability of the company. Hence, these assumptions should be made after critical evaluation so that company does not suffer financially, hence failing to make well-informed decisions.
Employees in the organization are given a number of paid leaves with an option of utilizing them or accumulating it for the future. However, at the time of retirement or the person leaving the company, if the employees do not utilize such leaves, they are needed to be compensated according to the company norms. This is known as leave encashment. The company, with reference to present as well as future circumstances, needs to estimate accurately its leave encashment liabilities so that unexpected liabilities do not arise in the future.
Mortality rates are essential to calculate as they impact finances of the company in the long run. These rates should be based on relevant present data with the company and also with reference to the expected future rates from the published data of the public. Assumptions on the mortality rate must be made accurately to avoid mishandling of funds.
Similar to the assumptions about mortality rates, retirement age assumptions also need to be made for better evaluation of future liabilities. Though this factor does not change as quickly as other factors, assumptions regarding this should be made as accurately as possible with reference to the retirement age set by the government and also according to the general rules set by the company.
1. Discount Rate:
2. Salary Escalation Rate:
3. Employee Turnover Rate:
4. Leave Encashment Assumptions:
5. Mortality Rate Assumptions:
6. Retirement Age Assumptions:
Is it necessary to consider actuarial assumptions?
There is no doubt about whether understanding actuarial assumptions is essential or not, it is crucial not only from companies’ point of view but also in general as managing funds of a company is much needed be it from any field. Following are the benefits of considering actuarial assumptions while making financial decisions of the company:
- Since, the business world is dynamic in nature, actuarial assumptions must be made and updated regularly so that the company does not lack funds to cover its liabilities and well-informed decisions are made timely.
- Financial stability of the company is maintained and financial surprises are minimized which is a good indicator with reference to handling funds.
- Since companies rely on actuarial assumptions to forecast future gains or losses, its correct estimation is ideal for any firm to better understand its present and required funds.
- If the estimation is inaccurate, or the company underestimates or overestimates required funds to cover future obligations, the company may become insolvent in future.
Conclusion
Thus, various actuarial assumptions are needed to be made to estimate future liabilities of the company. These assumptions must be made as accurately as possible so that companies do not suffer in the long run. Also, these assumptions must be updated from time to time, otherwise decisions made on incorrect or outdated plans can do great harm to the growth of the company.
Frequently Asked Questions
1. How can organizations improve their estimation and determination of actuarial assumptions?
Organizations can consult actuarial professionals to manage and estimate their future obligations with the help of actuarial assumptions on their behalf. They can analyze the trends and estimate using various statistical tools and techniques in a better way than others.
2. Can technology help to improve actuarial valuation assumptions?
Definitely, with the use of technology, organizations can better analyze the patterns and trends using past data, and make better and informed decisions regarding the future.
3. How are actuarial assumptions related to company valuation?
Actuarial valuation assumptions play a key role to determine future obligations to be fulfilled and thus has a direct impact on the company’s finances. Since, overall valuation of the company depends on such liabilities, accurately estimated these assumptions is necessary for better company valuation.
4. Which tools and software are used to estimate actuarial valuation assumptions?
Actuaries use various software and tools to analyze and calculate these assumptions like R, Excel, SAS, MySQL, Python, etc.
5. Are analyzing these actuarial valuation assumptions mandatory?
Yes, it is necessary to estimate these assumptions as required by AS 15 and IND AS 19(the revised version of AS 15) which set a list of guidelines to be followed while determining future obligations in terms of employment benefit schemes.