Impact of COVID-19 on actuarial valuation
COVID-19 pandemic has had a devastating impact on most businesses. One of the areas where companies have been hit hard is the cost of employee benefit schemes. Actuarial liabilities (Defined Benefit Obligation, DBO) have increased significantly, driven by a fall in discount rates. Apart from the adverse impact on the actuarial liabilities, there are other aspects of actuarial valuation which are affected by COVID-19, as we explain below.
5 ways in which COVID-19 affects actuarial valuation
1. Increase in actuarial liability because of a fall in interest rates
As evident from this chart, the interest rates have fallen substantially between 31 March 2019 and 31 March 2020. Most of the fall has been during the last quarter ended 31 March 2020. As the interest rates in the market fall, actuarial liabilities rise as explained in this post. Therefore, most of our clients have seen their liabilities and expense go up over the last financial year.
The impact of a rise in actuarial liabilities is likely to be partially offset by a rise in the value of assets, if the plan is funded. Most assets backing the actuarial liabilities tend to be fixed interest instruments, which also rise in value when interest rates fall.
2. Impact on mortality rates
This is a bit tricky to understand. So we explain it in a series of points:
- For gratuity and leave plans, usually mortality is not a material assumption. Therefore, any potential impact of mortality on the actuarial liability can be ignored, at least in the short term.
- For long-term post-employment plans, such as post-retirement medical benefits or pension plans, mortality is usually a very material assumption. However, it remains to be seen whether the novel coronavirus will have a lasting impact on the life expectancy. Answer to this question will depend on whether an effective vaccine can be developed, and whether the lifestyle changes are effective in limiting the effects of the virus. Current data suggests a high mortality rate for hospitalised cases, but the research on infection rates is limited. Therefore, currently there is no evidence to indicate that an adjustment to mortality rates is needed.
3. Impact on salary escalation assumption
Many companies have substantially reduced the salaries of their employees as the pandemic started to affect businesses. When this reduction happened prior to the close of the financial year 2019-20, the actuarial valuation would have factored in these salary reductions and the resulting actuarial liability would have been lower than what it would have been otherwise.
However, in most cases, salaries were reduced after the end of last financial year FY2019-20. Therefore, it is crucial to allow for these reductions in the salary escalation assumption. For example, a company which has been using a salary escalation rate of 10%, could use a tiered assumption, such as:
|Year||Assumed salary escalation rate||Description|
|FY2020-21||-15%||Year of the pandemic - allows for immediate salary reduction as well as any subsequent salary increment later during the year|
|FY2021-22||5%||Reflects a reduced salary increment to allow for the fact that the effect of the pandemic would run into the next year|
|FY2022-23 onwards||10%||The usual long-term salary escalation rate pre-pandemic|
Please note that this is just an example and how long it would take for the salary escalation rates to reach pre-pandemic levels should solely be based on the reporting company’s own best estimates.
Refer to this post for more information on how to set the salary escalation assumption for actuarial valuation.
4. Allowing for redundant staff
Many companies have significantly reduced the headcount in the aftermath of the pandemic. If employees have been made redundant post 31 March 2020, it is important that such employees are flagged at the time of actuarial valuation and a 100% attrition assumption is applied to these employees. In most cases, the pandemic is a post-balance sheet event; the impact should still be recognised in the financial statements for FY2019-20.
5. Impact on employee attrition rates
It is expected that more employees might loose their jobs as companies struggle to bring costs under control. To the extent that such redundancy exercise is expected, this should be allowed for in the actuarial valuation via the employee attrition assumption.
If a company has been using a flat attrition rate, consider using a tapered attrition rate assumption that varies for the next few financial years.
Refer to this post for more information on how to set the employee attrition assumption for actuarial valuation.
Companies reporting under Ind AS 19 or IAS 19 have been asking us whether the impact of COVID-19 should be allowed for in sensitivity analysis. In our view, and as explained above, the direct impact of COVID-19 on mortality is not expected to be significant. Instead, COVID-19 has impacted the businesses and economy significantly, e.g. discount rate, salary escalation rates and employee attrition rates. We provide sensitivity to these risks as standard in our reports. So, in our view, no more additional sensitivities need to be covered for meeting the requirements of Ind AS 19 or IAS 19.
However, from a risk management perspective, companies can choose to perform additional scenario testing. An example would be to construct scenarios wherein the impact of the pandemic continues over several years and then using varying set of assumptions for each year. Consider estimating the actuarial liability for 2-3 years into future to understand what the cost of running the employee benefit schemes are likely to be.
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