Actuarial Valuation of Employee Benefits under IFRS

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Actuarial Valuation of Employee Benefits under
IFRS

• June 17, 2009

Parth Khandelwal
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IAS19 Employee Benefits Scope
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IAS 19 Employee Benefits - Scope

• The Standard prescribes the accounting and
  disclosure by employers for employee benefits
• The Standard identifies following categories of
  employee benefits to be covered
• Short term employee benefits
• Post-employment benefits
• Other long term employee benefits
• Termination benefits
• It covers formal plans, state plans, constructive
  obligation (informal practices)
• This standard does not apply to benefits which
  needs to cover under the IFRS2 share-based
  payment
• This Standard does not deal with reporting by
  employee benefit plans (covered under IAS 26)
  e.g. accounting and reporting by trust plans

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Type of Benefit Plans

• Defined Benefit Some formula/Monetary promise.
• Defined Contribution Just contribution defined
  no promise of benefit.
• Hybrid Plans Where employers obligation is not
  limited to contributions to the fund but has
  legal or constructive obligation such as
• Scheme having benefit formula that is not linked
  solely with accumulation (hybrid schemes)
• Scheme providing guarantee, either indirectly
  through a plan or directly, of a specified return
  on contributions

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Whether a provident fund which guarantees a
specified rate of return is a defined benefit
plan or a defined contribution plan

• Provident funds set up by employers which require
  
• interest shortfall to be met by the employer
• would be in effect defined benefit plans in
  accordance with the requirements of IAS 19.

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Termination Benefits

• Termination benefits are employee benefits
  payable as a result of
• Employers decision to terminate an employees
  employment
• Employees decision to accept voluntary
  redundancy in exchange for those benefits
• An entity is demonstrably committed to a
  termination when, and only when, the entity has a
  detailed formal plan (with specified minimum
  contents) for the termination and is without
  realistic possibility of withdrawal.
• Where termination benefits fall due more than 12
  months after the balance sheet date, they should
  be discounted. In the case of an offer made to
  encourage voluntary redundancy, the measurement
  of termination benefits should be based on the
  number of employees expected to accept the offer

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Actuarial Assumptions
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IAS 19 Valuation Assumptions
Demographic Assumptions Mortality Morbidity Turnov
er/Attrition Disability Retirement

• FinancialAssumptions
• Discount rate
• Salary increases
• Expected Return on Assets

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How to set these assumptions?

• Set by employer
• usually with advice of actuary and auditor
• Best estimates
• unbiased and mutually compatible
• Financial assumptions market expectations at the
  balance sheet date
• over the period the obligations are to be settled

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Financial Assumptions

• Discount Rate

• To Discounts projected benefits
• Market yield on Government Bonds
• Duration of bond consistent with Duration of
  liabilities
• What is a Duration?
• What if my assets are in equities and making 20
  returns?
• Can I average out discount rate over 2/3 yrs
  periods?

Volatility Discount rate will change from year
to year as market based
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Financial Assumptions

• Salary increases

• To Determine future benefits based on final
  salary.
• Include inflation, promotion, seniority and
  market factors
• What if my salary increase for last three years
  was in to double digits?

Salary rates likely to be stable? or ..
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Economic Assumptions

• Expected Return on Assets (EROA)

• Long-term average expected return on the Scheme
  assets
• Higher EROA does it mean lower the liability?
• Is it expected to be stable or volatile each
  year?
• How to determine fair value of assets?

Expect stability in asset return
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Demographic Assumptions

• Mortality, Morbidity, Turnover, retirement rates
• Vary by age, seniority
• Turnover within first 5 years (Vesting) reduces
  gratuity liability
• Turnover after first 5 years (Vesting) may
  increase gratuity liability

Turnover assumptions can have major impact
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Effects of Changes in Actuarial Assumptions
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Actuarial Assumptions Discount Rate

• The rate used to discount post-employment benefit
  obligations shall be determined by reference to
  market yields at the balance sheet date on high
  quality corporate bonds
• In countries where there is no deep market in
  such bonds, the market yields (at the balance
  sheet date) on government bonds shall be used
• The currency and term of the corporate bonds or
  government bonds shall be consistent with the
  currency and estimated term of the
  post-employment benefit obligations
• However, AS15 (R) states that only Gilt Rate
  needs to be used without margin for corporate
  bond spread

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Actuarial Gain/Loss WHAT IS IT ?
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Actuarial gain/loss Liability
Extra years interest and benefit accrual
Liability Loss
Benefit Payments (leavers)
Liability
Year Start
Year End
Year End Expected
Year End Actual
Actuarial Loss/(gain) Actual liability -
Expected liability
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Actuarial gain/loss Assets
Contributions and Expected Investment Return
Asset Gain
Benefit Payments (leavers)
Market value of assets
Year Start
Year End
Year End Expected
Year End Actual
Asset gain/(loss) Actual - Expected market value
of assets
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Recognition of actuarial gain/loss Other
Standards

• IAS19
• Choice of Amortization
• Full and immediate recognition through PL
• - This results in volatility in profits and
  losses of company especially in case of
  significant change in gilt rate and change in
  fair value of unit-linked fund assets
• Amortization using 10 corridor over average
  future working lifetime of active members
• Full and immediate recognition outside PL via
  Statement Of Recognized Income and Expense
  (SORIE)

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How Corridor Approach work?

• Corridor approach can be used to delay
  recognition of losses / (gains)
• Corridor Approach amortizes over employees
  future service periods any unrecognized gains or
  losses in excess of 10 of greater of projected
  benefit obligation or fair value of plan assets

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Recognition of Actuarial Losses / (Gains)

• Corridor Approach requires to reconcile
  Unrecognized Losses / (Gains)
• Opening Unrecognized Losses / (Gains)
• Actuarial loss / (gain) on DBO
• Actuarial loss / (gain) on Assets
• Actuarial loss / (gain) recognized in the
  years P L
• Closing Unrecognized Losses / (Gains) to be
  carried forward

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Likely Changes in IAS19
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Likely Changes in IAS19

• The International Accenting Standards Board is
  discussing changes to the disclosures required
  and expect to come up with an exposure draft in
  the fourth quarter of 2009
• The likely changes would be
• Entities should recognize all changes in the
  value of plan assets and changes in the
  post-employment benefit obligation in the period
  in which they occur (immediate recognition)
• Replacement the term deep market with term
  active market and will define the term
• Alignment of the disclosure requirements for
  post-employment benefits with those in IFRS 4
  (Insurance Contracts) and IFRS 7 (Financial
  Instruments)
• Requirement of disclosure of the effect of plan
  amendments with a narrative description of the
  amendments
• The requirements under IAS19 will be more clearer
  after circulation of the exposure draft

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Employees Stock Option Plan
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Employee Stock Option Plan (ESOP) Valuation

• Right to purchase shares at specified price
  (exercise or strike price) over specified
  period (term), usually after completing a
  service requirement (vesting)
• If the stock price increases after receipt of the
  stock option, the individual can still buy the
  stock at the lower exercise price. So, they get
  the advantage of being able to buy stock at a
  price that is lower than that in the open
  marketplace
• Typical employee stock option
• exercise price stock price on grant date
• term 10 years
• vesting 33 or 25 per year starting on first
  anniversary of grant (full vesting after 3 or 4
  years)

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Multiple Valuation Approaches Exist

• Black-Scholes
• Most well-known and widely used
• Easy to use plug and play
• Values for all N(0,1) distribution
• Gives the discounted value of SP-X
• Static model
• Binomial
• Philosophically more accurate
• Dynamic allows for changing assumptions during
  life of option
• Calculates price paths, to enable price-dependent
  exercise modeling
• In addition, other valuation approaches exist,
  such as Monte Carlo
• Calculates a share price, using assumed criteria
• If SP gt X calculate SP X, repeat gt10,000 times
• Take average value of SP X and discount

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Employee Stock Option Plan (ESOP) Valuation

• All models attempt to value stock price less
  exercise price under various assumptions
• Companies would require assistance in valuation
  and expensing their share-based compensations
• Expect clients to express an interest in
  understanding the appropriate valuation
  model/approach for calculating the expense of
  employee stock options (ESOs)
• Does the binomial model provide a more accurate
  estimate of the value/cost of ESOs than
  Black-Scholes?
• What is the value/cost of ESOs?

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Employee Stock Option Plan (ESOP) Valuation

• In India, accounting for Employee SBP is guided
  by the requirements of the Securities and
  Exchange Board of India (SEBI) on ESOPs
  Institute of Chartered Accountants (ICAI)
  guidance note on Accounting for Employee SBPs.
• From 1st April 2011, companies in India may be
  expected to account for their Share Based Payment
  (SBP) differently under International Financial
  Reporting Standard (IFRS)
• Intrinsic Value Method Vs Fair Value Method
• Under the IFRS, the employee stock compensation
  cost is determined using the Fair Value Method

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How Mercer Can Help

• Mercer is Global Actuary for about 105 companies
• Mercer has also representatives on the Board of
  IAS
• Globally Accepted Actuarial Valuation Methodology
• Expertise in analyzing international accounting
  Standards IAS 19, US GAAP, AS 15 (R)
• Our Share Based Payment (SBP) valuation team has
  developed techniques and models which have been
  adopted by Mercer globally
• Mercer can aarrange actuarial valuation of
  employee benefits under different accounting
  standards IAS19, US GAAP, AS 15 (R)
• Gratuity Scheme
• Pension Scheme
• Leave Encashment Scheme
• Post-retirement Medical Scheme
• Privately Managed Provident Fund
• Employees Stock Option Plan

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Questions and Discussion
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