Projected Unit Credit (“PUC”)

Most Accounting Standards, such as IAS 19, US GAAP, Ind AS19 and others, require the Projected Unit Credit method.

The PUC prescribes the method to value accrued benefits, by reference to their projected amount at the date of payment.

This involves projecting each unit of benefit earned over a period plus earlier periods, to leaving service, retirement, death or other future exit states, allowing for probabilities of reaching those states, also allowing for salary escalation over time, and then discounting those benefits to the valuation date.

The resultant estimated liability amount reflects full expected service to each of leaving service, retirement or death, or other exit states.

The Current Service Cost is determined by dividing, for each employee, their total liability by total expected service and then aggregating the Current Service Cost for all members. The Current Service Cost can be viewed as the cost accruing over the next year, allowing for escalation and discounting to the different possible dates of payment.

To determine the Defined Benefit Obligation (“DBO”), we subtract from the total estimated liability the Current Service Cost multiplied by expected future service. This is, in effect, the liability that should be held at the date of the valuation, for service and benefits accrued up to the date of the valuation.

Differences between expectations and fact emerge as actuarial gains or losses and are amortised immediately the next year.

Pension Fund Accounting – Basic Example

A company has a defined benefit plan, such as an end-of-service benefit scheme. At the end of 2016, the fair value of the assets and liabilities amounted to $8 million. In 2017, the benefit expense was $10 million, and the company contributed $6 million to the benefit scheme. At the end of 2017, the fair value of the assets and liabilities was $13 million. Here are the basics:

We must record the benefit expense in the company’s books, debiting the expenses:

  • DR Benefit Expense 10,000,000
  • CR Defined Benefit Liability 10,000,000

To record company contribution to Benefit Liability:

  • DR Defined Benefit Liability 6,000,000
  • CR Cash 6,000,000

To adjust Benefit Liability to fair value as at the end of the FY or valuation period:

  • DR Other Comprehensive Income (“OCI”) 1,000,000
  • CR Net Defined Benefit Liability 1,000,000

IAS 19 Example

Real world examples are complicated. However, to help you understand, in a simplified manner, the general workings of the Actuary in determining the DBO, we ignore decrements (mortality, attrition) and only allow for a benefit to be paid on a retirement date.

Let’s say that a company pays an End of Service Benefit (“EOSB”) upon normal retirement age of 60 years. The benefit is defined as one monthly salary per every year of service (e.g. 20 years’ work will give 20 months’ salary as a one-off lump sum payment).

Our assumptions are as follows:

  • Salaries will grow at 5% for each future year
  • Interest/asset return rate is 4% per annum, based on quality bonds, 20-year term, given Expected Future service
  • Guaranteed employment to retirement
  • Death is not allowed!

The personal details of the one single employee are as follows:

  • Age at Joining Company:                               30
  • Age at Valuation Date (Now):                      40
  • Current Monthly Salary is:                     5,000
  • Normal Retirement Age:                               60
  • This means Past service is 40 – 30      = 10 years
  • This means Future service is 60 – 40 = 20 years (Expected Future Service)
  • This means Total service is 60 – 30     = 30 years (or 10 + 20)

According to IAS 19, the International Accounting Standards for Employee Benefits, the actuarial funding cost or valuation method to be used is the Projected Unit Credit (“PUC”) Method.

The simplified calculation stages are as follows:

  • Projected Final Salary = Current Salary * (1 + Salary Escalation) ^ (Future Service)
  •                                                 = Current Salary * (1 + 5%) ^ (60 – 40)
  •                                                 = 5,000 * (1.05) ^ 20
  •                                                 = 13,266 at retirement

 

  • Retirement Benefit      = Projected Final Salary * Total years service
  •                                                 = 13,266 * (60 – 30)
  •                                                 = 13,266 * 30
  •                                                 = 397,980 as a lump sum
  • Projected (all service) Gratuity Amount = 397,980 undiscounted

 

  • Projected Gratuity Benefit accrued up to age 40
  •                                                 = Projected Final Salary * Past Service
  •                                                 = 13,266 * 10
  •                                                 = 132,660 as the undiscounted DBO

 

  • Liability/DBO                   = 132,660 * (1 + interest rate) ^ (- future service)
  •                                                 = 132,660 * (1.04) ^ (-20)
  •                                                 = 60,544 after discounting, reflected in FS

 

  • Unit Normal Service Cost = Projected Gratuity Amount / Total service
  •                                                 = 397,980 / 30
  •                                                 = 13,266 per annum undiscounted

 

  • Normal Service Cost    = 13,266 * (1.04) ^ (-20)
  •                                                 = 6,054 Normal or Current Service Cost

This valuation assumes that there will be no service termination or other decrements. However, in real life situations, the actuarial valuation exercise will also consider decrements such as terminations, early retirements, disability, death, and so on.

The computation gets complicated; the actuary is professionally trained to deal with the mathematical intricacies and probabilities of various exit states, and the resultant impact on Expected Future Service and Discount Rate assumption.

IAS 19

The Standard for accounting for Employee Benefits, including benefits payable after the employee has left employment, is IAS 19 (2011). This Standard outlines the accounting requirements for Employee Benefits and requires extensive disclosures in respect of defined benefit plans, such as End of Service Gratuity schemes, including narrative descriptions of the regulatory framework, funding arrangements (if applicable) and potential (non-) financial risks.

The objective of the Standard is to prescribe the accounting entries and disclosures for Employee Benefits; it concerns itself with reporting the financial impact and position of Employee Benefits. This is, generally speaking,easy for short-term employee benefits,such as salaries or sick pay, that are costed as they accrue and are expected to be fully settled within 12 months of the annual reporting-end. But longer-term employee benefits, which include employee benefit plans or benefits required by law, are far more onerous to cost and report on. Such employee benefit plans could be part of a corporate reward structure, or otherwise offered on an optional basis which could be funded for separately. As the case may be, the typical structure is to promise a set of post-employment benefits (lump sum, pension, leave accumulation) on retirement or earlier termination or death of an employee. This means that cost is accrued over many years – and predictions made for future outcomes – which typically requires the involvement of a qualified and experienced actuary.

An IAS 19 Actuarial Valuation is required to cost these future, long-term employee benefit promises. An actuarial technique, called the Projected Unit Credit method, together with a set of actuarial assumptions,are used to make a reliable estimate of the ultimate cost to an entity of a benefit that employees have earned in return for their service.

The IAS 19 disclosure requirements are extensive and complex, for both financial performance and position requirements; typical disclosure elements include:

  • Annual employee benefit plan cost- split into numerous elements and booked in various ways. This includes past service cost or gain, current service cost, interest cost, benefits paid, actuarial gains or losses, exchange rate costs and more, booked to either P&L or OCI
  • Employee Benefit plan position, again with various elements, including Defined Benefit Obligation, and split between current and non-current liabilities
  • Methodology and assumptions bases, including long-term views on discount rates and salary escalation, where relevant
  • Various sensitivity and scenario tests, to illustrate possible or even likely divergence from the assumes basis and methodology.

IAS19 includes valuation and treatment of such benefits as provided:

Short-term employee benefits

The benefits to be settled within 12 months, other than termination benefits. Examples include wages, salaries, profit-sharing and bonuses and non-monetary benefits paid to current employees.

Post-employment benefits

The benefits that are payable after the completion of the employment. Examples include Gratuity, Pensions, Lump sum payments, life insurance and medical care etc.

Plans providing post-employment benefits are classified as either defined contribution plans or defined benefit plans, depending on the economic substance of the plan as derived from its principal terms and conditions:

  • A defined contribution plan is a post-employment benefit plan under which an entity pays fixed contributions into a separate entity (a fund) and will have no legal or constructive obligation to pay further contributions if the fund does not hold sufficient assets to pay all employee benefits relating to employee service in the current and prior periods. Under IAS 19, when an employee has rendered service to an entity during a period, the entity recognises the contribution payable to a defined contribution plan in exchange for that service as a liability (accrued expense) and as an expense, unless another Standard requires or permits the inclusion of the contribution in the cost of an asset.
  • A defined benefit plan, where a benefit is defined typically in terms of length of service and some form of final salary – such as the End of Service Gratuity prevalent in the GCC. Under IAS 19, an entity uses an actuarial technique (the projected unit credit or PUC method) to estimate the ultimate cost to the entity of the benefits that employees have earned in return for their service in the current and prior periods; discounts that benefit in order to determine the present value of the defined benefit obligation and the current service cost; deducts the fair value of any plan assets from the present value of the defined benefit obligation; determines the amount of the deficit or surplus; and determines the amount to be recognized in profit and loss and other comprehensive income in the current period. Those measurements are updated each period.

Defined Benefit Obligation

Defined Benefit Obligation or Liability (or DBO) is the discounted present value of all expected future obligations resulting from service rendered by the employee, up to and as at the valuation date.

This requires use of actuarial valuation method such as attributing benefits to expected period of service and using the various assumptions used to measure the defined benefit obligation including Demographic (mortality rate, attrition rate) and Financial (discount rate, salary escalation rate, expected rate of return on plan assets) assumptions.

To determine the DBO, the Projected Unit Credit actuarial method (or PUC) is required by IAS 19.

If there is any corresponding plan or scheme assets, we take them into consideration by deducting the fair value of those plan assets from the present value of the DBO.

Current Service Cost

For any employee, it would be prudent for a company to bear the cost of the employee’s eventual leaving service benefit or gratuity, from the start of the first day of employment. To develop that thought, the company should attribute the expected amount of that gratuity cost to the current year – as that cost is incurred. This cost to the company is known as Current Service cost.

To define more precisely, the Current Service Cost is the increase in the liability resulting from members serving an additional period (year or quarter or month) during the reporting period. An additional period of service increases their liability in proportion to their total liability and total service period (actual and expected) under the Projected Unit Credit Method.

For the technical minded, we calculate the annual Current Service Cost by dividing the total Lifetime Actuarial Liability of the employee by the total actual and expected years of service. This annual Current Service Cost is adjusted for non-annual reporting periods.

For clear calculative understanding, visit our illustration for different elements in calculation of current service cost, interest cost and others.

Interest Cost – why?

This is the cost of an increase in the liability resulting from expected future benefits being one year/period closer to being paid at the current valuation date compared to the last valuation date.

The actuarial liability is the present value of the benefits that will be paid to employees at the time of their retirement or earlier termination. So, the opening actuarial liability at the start of the year is the present value (ie discounted value) of the liability that the entity owes to its employees as at the beginning of the year. By the end of the financial year, this liability is discounted for one year less, all else being equal, compared to the start of the year. This reduced discounting means a higher liability, which is the Interest Cost.

Another way of viewing of the Interest Cost is that it is an “unwinding” of the discount rate for one year, compared to the valuation one year earlier. The discount rate is applied to the liability at year start, to obtain the interest cost.

If a scheme has backing assets, matching exactly the liabilities, at year start, and those assets earned the assumed interest (ie discount) rate, then the earnings would exactly offset the Interest Cost and the net cost to the scheme would be zero.

First-time adopter of IAS 19

An entity adopting IFRS for the first time has to conduct the actuarial valuation at the beginning of the financial year in which IFRS will be adopted. The difference between the opening actuarial liability and the liability that is carried in the books of the accounts should be recognised under “Past Service Cost”, so that the opening employee benefits liability in the books of accounts is equal to the opening actuarial liability for the financial year. This Past Service Cost will then be transferred to the Profit & Loss Account.

Hence, it is imperative to conduct the actuarial valuation as at the beginning of the financial year. Some of our clients request us to conduct just the valuation as at the end of the financial year in which they will be adopting IFRS for the first time. But we always recommend to them that a valuation needs to be conducted as at the beginning of the financial year.

Illustrative Example

Entity ABC Limited is reporting under IFRS for the first time in financial year 2017. The End of Service Benefit liability using the traditional formulaic and non-actuarial approach was SAR 410 million as at 1 January 2017.

ABC Limited appointed Lux to conduct the actuarial valuation for FY 2017.

Lux, accordingly, conducted the actuarial valuation for ABC Limited as at 1 January 2017 and 31 December 2017. The actuarial liability (“DBO”) Lux computed as at 1 January 2017 was SAR 425 million. Hence, the difference between the opening book liability (SAR 410 million) and the actuarial liability (SAR 425 million), i.e. SAR 15 million, is charged to Past Service Cost.

For ease of understanding, the journal entries should be as follows:

1. Journal Entries

1.1 Case of Past Service Cost

Past Service Cost                                                                 15
To End of Service Benefit liability                                                             15

This will ensure that the opening book liability in the year of adoption is the same as the actuarial liability.

This Past Service Cost should be transferred to the Profit & Loss A/c for FY 2017.


Profit & Loss A/c                                                                 15
To Past Service Cost                                                                                    15

1.2 Case of Past Service Gain

If the actuarial liability is SAR 400 million instead of SAR 425 million, then the difference of SAR 10 million should be charged to Past Service Gain.

End of Service Benefit liability                                      10
To Past Service Gain                                                                                 10
Past Service Gain                                                               10
To Profit & Loss A/c                                                                                   10

Given that the opening book liability is now the same as the actuarial liability, ABC Limited can use the relevant accounting disclosures for FY 2017, provided in Table 7.1 of our valuation report, to recognise the current service cost, interest cost, and the actuarial gain or loss in their books of accounts.

Discount Rate – GCC

For IAS 19 purposes the discount rate used is determined by reference to market yields at the valuation date on high quality corporate bonds or, where there is no deep market, by reference to market yields on Government Bonds with the same duration and currency as that of the liability. High-quality corporate bonds would mean bonds with credit rating of at least “AA” from a reputable credit rating organisation.

For the GCC (KSA, UAE, +) the size of bond market(s) is not deep. Thus, reference needs to be made to Government Bonds. Even so, Government Bond markets for issues in SAR or AED are not deep, they are illiquid and the bonds are not traded frequently. Thus, for KSA, we generally refer to the Saudi Government Issuance of dollar denominated bonds. These bonds are liquid, marketable and the market price of these bonds is publicly available.

Alternatively, given that the SAR is pegged to the US Dollar, we base the discount rate on US bond yields with an additional country risk premium for KSA compared to the USA. In this approach, quantifying the Country Risk Premium is very subjective but a 1% risk premium can probably be reasonably assumed. (This might not hold true in future readings of this post.)

Typically the duration of the liability for EOSB for companies in KSA is around 12~13 years and at this duration, we occasionally update our views here.

30 June 2019

4.1%

31 March 2019

4.5%

31 December 2018

5.1%

30 September 2018

4%

Please note that the duration of the liability is derived by computing the weighted average term (years) of the expected future benefit payment arising from the Scheme Benefit. The weight of each benefit payment is determined by dividing the present value of the sum of the future benefit payment. Thus, for determining the duration, the actuary forecast all the expected future cash flows arising from the Scheme and their expected timing of the payment.

Further, the duration of the liability is dependent on the assumed attrition (withdrawal) rate. The higher the withdrawal rate, the shorter the (expected) service duration, and vice-versa. Also, typically, the longer the service duration, the higher would be the discount rate.

Actuarial Gain or Loss

For any periodic valuation of the defined benefit plan such as End of Service Benefit, the actuarial gain or loss arises because of two reasons:

1.1 Due to change in the valuation assumption

For any actuarial valuation, the entity needs to make assumptions – financial assumptions (discount rate and salary escalation rate) and demographic assumptions (mortality rate and withdrawal rate). If there is a change in the assumptions from last valuation to the current valuation, then the change in liability due to a change in assumption(s) is quantified under Actuarial Gain or Loss due to change in the valuation assumption.

For example, for the last valuation the entity used the discount rate of 4.5% while for the current valuation the entity used the discount rate of 4%. Due to this change, there will be an increase in the liability and it is calculated by running the current valuation payroll assuming the discount rate of 4.5% keeping everything the same. The difference between the liability at 4% discount rate and 4.5% discount rate will be classified as Actuarial gain or loss due to the change in the financial assumption.

1.2 Due to the experience of the Scheme

This is due to the actual experience of the Scheme from the last valuation to the current valuation differing from the assumption(s) made at the last valuation.

For example, the salary escalation rate was assumed to be 4% for the last valuation (say 31 December 2017), while the actual salary escalation awarded to the employees during FY 2018 is 5%. Then, while valuing the liability as at 31 December 2018, there would be an actuarial loss due to the experience of the Scheme being different from the assumption made, that being higher salary increases awarded – 5%, and benefits growing faster than assumed – 4%, leading to a larger liability than expected.

Where is the Actuarial Gain or Loss charged to?

Under IAS 19, the actuarial gain or loss is not charged to Profit & Loss Account but transferred to Other Comprehensive Income. This ensures that the impact of the change in the actuarial assumption or any volatility in the actual experience do not distort the profitability of the entity.

If you need to understand in more detail the actuarial gain or loss then contact us here at Lux. At Lux, our report contains the detailed explanation of the source of the actuarial gain or loss which help our clients and their auditor, any abrupt increase or decrease in the liability or defined benefit obligation.