With contribution to the pension fund and benefits arising due to rising interest rates, there has been a steady decline in the gap between pension assets and liabilities. The gap which increased in 2016 has been narrowed with a higher share of contribution in 2017, according to a Kotak Institutional Equities Report.
In the financial year 2017, the gap between retirement assets and liabilities were at the lowest point in the past decade for public banks. The gap almost closed as the charges taken in profit and loss (P&L) in fiscal 2016 resulted in a higher contribution to the plan in 2017. The contribution by employer remained high since 2010 mainly due to meet the revised benefits offered.
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The gap has significantly narrowed in recent years though there will be some difference between assets and liabilities each year. This happens largely due to the mismatch that arises between ascertaining the liabilities which happens at the end of the financial year and the contribution to meet this shortfall made by the bank at the beginning of the next financial year. However, now the banks have reached normalised levels of mismatches.
Funded status means the status of the pension plan that has accumulated assets that have been set aside for the payment of retirement benefits to employees. It equals to present value of the defined benefit obligation minus the fair value of plan assets. In case, the plan obligations are more than the plan assets, then the plan is underfunded or has a deficit; otherwise the plan is overfunded or has a surplus. The underfunded plan is reported as net pension liability whereas the overfunded plan is posted as net pension asset.
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Timing difference between contribution and expense
There is always the possibility of some degree of mismatch as there is a timing difference between contribution and the expense charged in profit and loss. It is seen that the contribution by employer to the pension fund has been rising to cover the shortfall. In 2017, the contribution to the scheme was 150 per cent of the P&L impact as compared to 70 per cent in 2016.
As of 2017, the total contribution to the fund by banks as compared to the costs reported for retirement expenses, increased to 1.5 times of the required contribution expensed to the earnings statement. The difference in contribution and expense charged could partly be a timing issue for a few banks as the change in assumptions made on mortality tables for a few banks may be fully visible in 2017. Certain banks make their contributions to the fund in the subsequent financial year, though the P&L reflects the cost at the end of a financial year.
60 bps dip in assumptions on long term interest rates
The pension obligation and pension expense is based on several assumptions such as length of service, rate of increase in compensation levels, employee turnover, employee’s life expectancy, discount rate and expected rate on plan assets. The assumptions continue to remain a source of concern however, there is very little that a bank can do to make changes in a few of them. Discount rates for capturing long term liability costs and expected return on planned assets are linked to long-term benchmark instruments.
In fiscal 2017, the assumptions plummeted by a higher rate of 60 basis points (bps). This sharp decline in interest rates only increased the present value of the future liabilities by 12 per cent on year to year. In what appears to be a possible relief to address the impact during declining interest rates, the changes have limited impact in 2017.
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Banks’ response to the decline in assumptions
Banks have made a steeper decline in changes to assumptions between assets and liabilities. On the liabilities side, banks have reduced their long term interest rate, which is positive, as it better reflects the underlying liabilities. The decline is material with a change of ~60bps to 7.4 per cent with a similar decline in the change on the long term return on assets at 8.1 per cent.
Banks have reported a net loss due to this change as the increase in liability during declining interest rates is higher as compared to the gains on account of revaluation of assets. This scenario will start to reverse when plans reach their full maturity. Moreover, long term life expectancy could have led to increase in liabilities.
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Greater impact from actuarial assumptions could reflect aggressive assumptions
In 2017, actuarial losses rose further but this was lower than in 2016 and could possibly be explained by minor modifications to assumptions. Given limited disclosures, it is difficult to point out factors leading to actuarial impact, but these losses could reflect the aggressive assumptions made by banks and hence could potentially report higher actuarial losses for an extended period.
There can be varied reasons for the actuarial impact, one of them is the difference between observed and assumed variances in the age of a pensioner post his retirement. Although, this will remain a problem for some time, however this is not to get disturbed as most of these plans are at a fair level of maturity given the levels of retirement that we are seeing in this employee base.
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Another reason could include factoring new actuarial tables of 2006-08 as compared to 1994-96 tables or secondary impact caused due to marginal changes in salary on a yearly basis such as promotions.
Why worry about interest rate assumptions?
It is important to note that the high interest rate assumptions do not have similar impact on the fair value of assets and defined benefit obligation. The present value of defined benefit obligations is likely to increase with decline in long-term rates. Also, this will increase the pension costs as the current service costs and pension obligation both increase with the decline in discount rate.
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To calculate pension obligations, companies need to make several assumptions such as future compensation increases and levels, discount rates, and expected vesting. Any changes in the assumptions will change the estimated pension obligation. An increase in pension obligation resulting from changes in actuarial assumptions is considered an actuarial loss, and a decrease in pension obligation is considered an actuarial gain.
Re-opening of second pension option
Public banks have completed a key journey in 2015 with respect to provisions for the second pension option which started in the year 2011. The fiscal year 2015 was the last year of amortisation of the re-opening of the second pension option.
Employer contribution higher in 2017 for gratuity
The contribution by employer to the gratuity fund was marginally higher in 2017. The gratuity benefits charged to P&L is much lower; on an average the costs related to gratuity is 10 to 15 per cent of the pension related costs. For fiscal 2017, the cost to earnings is less than 5 per cent over the last few years. Hence, gratuity is of lesser concern as its cost is only two to five percent of reported staff costs.
Decrease in retirement costs to overall staff costs
The retirement costs to total staff costs which had increased to 28 per cent in fiscal 2016 moved back to 20 per cent levels. Operating expenses remain at elevated levels with retirement costs contributing 20 per cent of the overall staff costs for the bank.
The pension benefits charged to P&L to total staff costs declined in financial year 2017 primarily on account of Bank of Baroda (BoB). During 2016, BoB had changed its mortality tables resulting in higher expense in the P&L, which made the contribution to the fund in 2017 resulting in the sharp variation between contribution and charge.
Active employees under defined contribution may have crossed 50 per cent
Every company measures the retirement benefits that are provided to their employees. The post employment benefits offered are in form of two plans: defined contribution and defined benefit plans.
In a defined contribution (DC) pension plan, specific (or agreed upon) contributions are made to an employee’s pension plan. Apart from this agreed-upon contribution, the employer has no other obligation. The future value of the benefits to the employee depends on how well the investments perform. Thus in this plan, the employee bears the investment risk.
In a defined benefit (DB) pension plan, the pension benefit is defined and offers guaranteed payouts to employees post retirement, which is a function of years of service and compensation level at retirement. Future pension payments represent a liability for the employer and need to be estimated. In a DB plan, the employer bears investment risk.
In other words, the DB pension plan is retirement plan that requires an employer to make contributions into a pool of funds set aside for an employees’ future benefit. The pool of funds is invested on behalf of the employee and the earnings on the investments generate income to the worker upon retirement, also known as the plan assets. Plan assets are the investments of the pension fund.
The data shows that the ratio of employees who are currently part of the defined benefit plan and active have fallen to 50 per cent levels as compared to 94.5 per cent in 2011. The PSU banks are moving swiftly to defined contribution plans; the banks switched to DC plans on August 01, 2010 as employees contribute 10 per cent of basic pay and dearness allowance with a matching contribution from banks.
As 50 per cent of the employees are now outside the defined benefit scheme, the peak liability creation closes at active employees – not all employees start declining. However, the assets that are created need to be in existence till the last member is active in the plan post his retirement.
The employee payouts are declining on year to year basis; the decrease in the share of active employees who were part of the defined benefit plan suggests that the issue of retirement costs for public banks is fading away rapidly.
Current service costs movement under DBO
Service cost is the amount by which a company’s pension obligation increases as a result of employees’ service. To understand the current service costs movement under defined benefit obligation, one would need to track the ratio - share of active to retired employees in the plan or in other words, the split of employees in the plan between active and retired employees and also the outstanding liabilities assumed by the bank for these employees. The increase in current service cost which represents the employees’ contribution increased by 7 per cent year on year basis
Evidence suggest that the ratio of employees who are in defined benefit to total employees is about 35 to 45 per cent today as compared to less than 10 per cent in 2011. This is a function of new hiring under defined contribution.
On the other hand, in the next few years, the ratio of active employees to those who have retired is likely to reverse. Discussions with various banks indicate that active employees in the defined benefit scheme have declined to 55 per cent levels in 2014 from 65 to 70 per cent levels in 2011. There is higher probability that this can decrease to 45 to 50 per cent or lower by 2017 for most public banks. This would also result in keeping the average cost per employee closer to current levels. In the short term, some of the public banks are expected to report single digit growth in average staff costs.
The decline in the ratio- share of active to retired employees in the plan decreases the pace of increase in the current service costs which indicates that the plan is closer to maturity. The duration of the creation of liabilities because of the change in active employees is lot lower than the duration of the assets required to service all employees; where both the duration of liabilities and assets are indirectly checked through the change in current service cost.
The ratio of share of active to retired employees in the plan can also be tracked through various reported items such as increase in current service cost, relative contribution of interest costs as compared to current service cost and benefits paid. The former two - current service cost, interest costs are heavily influenced by the discount rate and salary escalation assumptions whereas the benefits paid are more reliable.
The data shows that the trend in benefits paid to opening balances is steadily rising; however, this has a key drawback flaw as it is not necessary that the opening balance is factoring the full cost of the liabilities that needs to be paid. Given the limited data, it is possible to think that the third option does offer a better alternative. It is important to note that many banks adjust the difference in expected cost and actual costs under actuarial losses. Hence, the one-time cost taken by SBI in 2014 could possibly be taken across a wider period by all public banks.
The banks should be able to manage this liability as they are still in a strong growth phase in their balance sheets, over 10-12 per cent CAGR in the medium term which gives adequate cushion for higher-than-expected contribution while the defined benefit plan witnesses a steady decline of members.
Employee mix
The employee mix is changing positively leading to a decline in age and maturing retirement plans, which is positive for public banks. Given the extent of disclosures and changes in many variables on defined benefit obligation, it is very hard to get accurate data from what is already available.
However, looking at the various disclosures, such as share of benefits paid in the overall fund; 60 per cent share of interest costs to current service costs, and the move to switch to defined contribution from defined benefits for new employees indicates strong signs of this showing a possible mature plan.
Chances of increase in employee costs for PSUs
During 2017, the staff costs per active employee have increased by one per cent year on year for public banks while it has increased by 5 per cent for private banks. The employee costs increased 7 per cent on year on year basis in 2016 and greater than 33 per cent higher than private banks. The consistent rise of staff costs has created a sharp divergence where it appears that the average cost per employee is 30 per cent higher for public banks. This could be partly true as the average age of employees is far higher at over 40 years as compared to 30 years for private banks.
This analysis is not correct as 25 to 30 per cent of the reported costs are related to retirement benefits where the contribution is closer to peak levels. The probability of the reversal is very high, though not immediate. For public banks, this ratio can be at closer levels and probably start declining in a few years from now.
The ‘decline’ in the ratio is based on the mix of employees in these banks. The average age of employees in public banks has started to reverse. For example, the average age of employees in Punjab National Bank has declined to 40 years as compared to 50 years in 2010. With more retirements coming through in the next few years, the average cost is likely to decline and unlikely to increase any further from current levels.
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