Actuarial Techniques in Pensions and Employee Benefits

As an employee of the firm, one is always fascinated by the various employee benefits that the firm provides. These benefits lure the employees to work dedicatedly for the organization. Actuarial techniques in pensions and employee benefits, may seem alluring but were you ever intrigued by the fact that what it takes to provide such benefits by the organizations, how do they go about it and who helps them in valuing these benefits?

That’s where the actuaries come into the picture and the various actuarial techniques play a significant role. For a layman, employee benefits are simply the non-salary compensation provided by the employer to create a competitive package for the potential employees. Employee Benefits include medical insurance, retirement plans, child care spending, paid leaves, paid vacations and the list goes on.

Among all the above benefits, pension given to employees posts their retirement is very crucial and needs to be modeled accurately so that the employer is able to meet his liability at the time when it’s due.

In this article, we will see how the actuaries design the company’s pension schemes.

Actuarial cost is simply the money that the company sets aside periodically to meet the future pension liabilities. This approach takes into consideration an employee’s current salary, the number of years to retirement, annual rate of salary increment, probable number of years the individual will live to continue getting the benefit etc. It has two approaches:

  1. Cost Approach: It estimates the total retirement benefits to be paid in the future and then determines the equal annual payments that are necessary to fund those benefits.
  2. Benefit Approach: This calculates the benefits that the employees have already received based on the length of their employment. In other words, we can calculate the amount of benefit associated with employees’  service to date and use a discount factor to reduce the benefit to its present value.

Another approach to valuation is Defined benefit (DB) and Defined Contribution Scheme (DS).

Defined benefit: It is the amount that the employer promises to pay to the employee at the time of retirement which is predetermined by a formula. The pensionable salary is derived  using either of the three ways:

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  • Current Salary
  • Average salary of 3 or 5 years
  • Career average salary

Once the pensionable salary is derived appropriate formula is used to get the benefit.

Defined Contribution: Here the employer and the employee both contribute to the pension fund according to a specified percentage. Here the benefit is not known beforehand.

Annual Contribution= Contribution x (Current Pensionable Earnings)

In general, the above is the pictorial view of the employee defined benefits (eg – gratuity, pension etc) actuarial valuation process –

Step 1: Collection of data- This involves fetching information such as employee joining date, DOB, current salary, employee’s contribution made during the period etc.

Step 2: Actuarial assumptions are made for the discount rate, expected future salary, mortality rate, withdrawal rate.

Step 3: This includes calculations of the present value of all the payments to be made from the date of retirement until the death of the employee.

Step 4: It involves meeting the various disclosures that are required to be adhered according to Indian Accounting Standard (IAS) 19 by the companies.

Step 5: This requires the companies to identify the key risks and keep an eye on the various assumptions that were initially taken before.

Step 6: Carrying out the actuarial gain/loss analysis.

Thus, this is how the actuary works in modeling the pension liability of the firm.

Also, it should be noted that when the companies make the pension reserves, it is reflected in it’s financial statements. It generally records the funding cost as an expense and the total accumulated future pension payments as a liability.

The above are some of the ways in which the pension models are designed. There are yet another complex models that the actuaries use to help companies value their employee benefits and make appropriate decisions to fund those liabilities.

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