Employee attrition rate is an important assumption that can have significant impact on the actuarial liability of employee benefit schemes. An incorrect assumption will invariably lead to erroneous liability to be recorded in the balance sheet.
In our last post, considerations for setting the salary escalation rate were discussed. In the same post, we also provided some context about the roles and responsibilities in regard to setting actuarial assumptions and owning the process of actuarial reporting in general. In a nutshell – prior to 2005, actuarial valuation, including the assumptions, was largely controlled by the actuary. This situation changed when AS 15 was revised in 2005 and the responsibility for all aspects of actuarial valuation was shifted to the reporting companies.
This post is aimed at helping companies in selecting the attrition assumption for actuarial valuation in order to be compliant with the requirements of Indian GAAP.
7 things to understand about attrition assumption for actuarial valuation
Considerations applicable to the process of setting employee attrition rate are similar to salary escalation assumption. Most significantly, both these assumptions reflect the expectation of the (unknown) future experience. Here are a few things to be aware of:
1. Understand the regulations – essentially, both AS 15 and Ind AS 19 require that an assumption be made about how many people are expected to leave the service of the employer in future. The point to note here is that the assumption is made about future, not the past. The past experience should only be used as a guide to set the assumption.
2. Do not blindly set the attrition rate assumption to be equal to the attrition rate over the accounting period, or any other measure of historical employee attrition. The historical attrition is only a guide to setting the assumption and must be adjusted to reflect the events expected to happen in future. For example, a company may have experienced an attrition rate of 12.58%, but if the company personnel expect that the future experience will be just 5%, e.g. due to a retention plan being rolled out, then the assumption should be 5% and not 12.58%.
3. Generally, companies make assumptions about future attrition for business planning purposes such as recruitment, redundancies, budgeting etc. Attrition assumption should be consistent with these business plans. However, a distinction must be made between the ‘business’ attrition assumption, which would allow for new employees that will be recruited in future, and the ‘actuarial’ attrition assumption, which only relates to the expected attrition of the existing employees. Since the attrition rate decreases as the employees stay longer, one may expect the actuarial assumption to be somewhat lower than the corresponding business assumption.
4. The attrition assumption for actuarial valuation must allow for all sources of attrition likely to happen in future, for example, any redundancies planned in future. These sources may not be adequately captured in the past attrition.
5. When setting the attrition assumption, it is important to understand that the assumption is not being set for the next year alone. The assumption is a ‘time-average’ of attrition rate over a long-term, generally agreed to be the term equal to the duration of liability. The historical attrition experience will be volatile, and using that as the sole basis for attrition assumption will create unnecessary volatility in the actuarial results.
6. As far as possible, the attrition assumption should not change year on year, unless the company’s view about future attrition is changed. There will be years in which attrition will increase or decrease because of random fluctuations, but having a year of higher or lower than expected attrition does not mean that the assumption needs a revision.
7. Using a staggered attrition rate assumption can often improve the accuracy of an actuarial valuation and make the results more stable. For example, companies can set different attrition assumption for different cost-centres or locations. Attrition assumption that varies with time in service or attained age, can also be used. This is particularly useful for small companies whose employees have accrued considerable past service.
Separate posts are available providing guidance on setting the discount rate and salary escalation rate. Future posts will provide an understanding of other actuarial assumptions.
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