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Actuarial valuation of a benefits plan requires the use of financial projections, known as "Actuarial assumptions" in order to measure the expense and/or liability. These assumptions are estimates of key indicators that are directly used to calculate the employees defined benefits or retirement benefits obligations. The assumptions are selected based on a best estimate method - in other words, as a reasonable estimate based on cogent understanding of the business plan and the financial environment in which these benefit plans operate. They are often derived at, taking into account the margin for error that may occur due to adverse deviations, and with the overall idea to minimize volatility from one year onto the next.
Actuarial assumptions can be broadly classified into two categories - Economic assumptions and demographic assumptions. Economic assumptions relate directly to the financial inputs, such as the rate of salary growth of the plan's participants, the expected return on the fund’s assets and so on. Demographic assumptions relate to a pension plan’s membership, such as changes in the number of working and retired plan participants; the retirement age of the participants, and the expected age of the plan participants.
Key Actuarial Assumptions
Some of the important assumptions for benefits valuation include the discount rate factor, salary escalation rate and the attrition rate.
Figure: Actuarial Assumptions for employee benefit valuation
The discount rate factor is a significant actuarial assumption. It enables us to state expected future cash payments for benefits as a present value on the measurement date. This is referenced to market yield rates, and this does not allow much room to capture specific details by an organization policies. A lower discount rate increases the present value of benefit obligations and increases the expense for retirement obligations.Salary Escalation Rate
The salary growth rate is also a key assumption for the actuarial valuation process. Ideally, this should be a calculated and viable estimate, capturing the standard rate of increase in salary per annum for an average employee - possibly for the next 10 years or the future working life time of a hire. This rate can be driven by the business performance of the company, and would include components such as annual increment, promotional increases, one time bonuses and also inflationary increases. The HR policy of the company also plays an important role in setting this assumption, and the salary escalation rate is often benchmarked alongside industry trends. It is worth noting that in India, salary escalations have been high in the recent past and for each company, a concise view has to be taken as to how long this trend is expected to continue. We generally assume salary growth between 6% to 10% per annum. However, for an organization which is actively expanding its recruitment policy, or striving to retain talent, the escalation rate may vary significantly. We may also think of a high rate of say 10% or 12% for the next five years and thereafter a lower rate say 7 to 8%. This assumption should capture the long term trend, and also capture price inflation and GDP performance, among other key indicators.Attrition Rate
The Attrition rate assumption measures the number of individuals moving out of an organisation. Attrition rate tends to be specific to industries, or even companies on a micro level. In certain industries, this assumption can vary drastically in the younger demographic of employees. It may be a good approach to weigh out the attrition rates over the past few years and create a benchmark. Incorporating the company's policy towards performance based HR strategies and retention polices can help to reduce the attrition rate. For valuation purposes, a reasonable rate based on your company's context would be a good starting point. An age or pay grade wise split up would help in reducing the margin of error.