By Daniel Dickinson
Daniel Dickinson, senior executive officer at PraxisIFM, explains how companies can plan for end of service benefits
Ultimately, whether the government rethinks the end-of-service benefit scheme, or whether employees make better plans for themselves, there is still a need for companies to better manage the system and their readiness for paying it whenever an employee – particularly a long-serving one – leaves.
By creating an end-of-service gratuity scheme and implementing a long-term funding and investment strategy, employers can manage their gratuity liabilities in a cash-efficient manner.
It’s important to note that gratuity schemes are legally separate from the employer company and hold assets to help fund an employer’s gratuity liability and thereby provide comfort to employees that their gratuities are not at risk.
At Praxis, we often speak to employers who have not set up a gratuity scheme because they are reluctant to fully fund their liabilities on day one. But this creates a significant “funding gap” of the kind that is now facing mature markets such as the Eurozone and the UK that has sparked a number of initiatives in the defined benefit industry to deal with this problem – especially as interest rates continue to hover around all-time lows.
Here in the UAE, at least, employers and gratuity schemes need not worry about factors such as life expectancy and future interest rates when forecasting their gratuity liability.
By using their own employment data, and factors such as wage growth and attrition rates, we can accurately model an employer’s total liability and how those liabilities will develop in the medium and long term. This certainty gives the employer and the gratuity scheme much greater certainty as to the liabilities and gives them clear benchmarks for funding them.
So how can an employer make use of a gratuity scheme to manage their current and future gratuity funding obligations?
End of service schemes can utilise higher return assets to reduce the levels of funding required over the duration
Contrary to popular belief, a gratuity scheme does not have to be fully funded on day one. If an employer implements a progressive funding plan over a number of years, they can manage the build-up of the gratuity scheme assets in a manner that suits the operating cash flows of their business and reduces the overall cost of funding their gratuity liabilities.
When considering funding strategies, it is necessary to understand the existing liability and how that liability is forecast to develop in the future. With the correct analysis of historical employment data, it is possible to model how the total gratuity liability will evolve in the short, medium and long term and then develop a funding strategy.
The main question we get asked is should an employer implement a “fund now” strategy or a “fund later” strategy?
A fund later strategy may appear attractive but kicking the can down the road increases the total cash requirements, and the lack of gratuity security can unsettle employees. A Fund-Now strategy, meanwhile, requires more cash funding in the early years but, as highlighted below, a long-term investment strategy and lower scheme costs can significantly reduce the total funding cost and increase staff retention.
Now that employers have to adopt International Financial Reporting standards, companies have to recognise their unfunded gratuity liabilities on their balance sheets and make extensive disclosures about their unfunded liabilities in their financial statements. Having a clear funding strategy will reassure shareholders and other users of the financial statements.
Gratuity schemes are not subject to any investment restrictions and can therefore invest in higher return assets. European pension schemes have been forced to invest in fixed income assets and this has meant that scheme assets have not kept up with liability growth. This has increased the burden on employers to make large contributions to fill the funding gap.
End of service schemes can utilise higher return assets to reduce the levels of funding required over the duration of the scheme. Many investors perceive that equities are higher risk than bonds but in the long term this is generally not the case.
In his 2017 letter to shareholders, Warren Buffett confirmed our own long-term analysis of the returns generated by diversified portfolios of stocks and bonds between 1871 and 2017, namely that it is a mistake for investors with long-term horizons to think that a portfolio of bonds is lower “risk” than a diverse portfolio of equities.
In Buffet’s own words: “I want to quickly acknowledge that in any upcoming day, week or even year, stocks will be riskier – far riskier – than short-term US bonds. As an investor’s investment horizon lengthens, however, a diversified portfolio of US equities becomes progressively less risky than bonds, assuming that the stocks are purchased at a sensible multiple of earnings relative to then-prevailing interest rates.”
Over the long term, a diversified portfolio of equities has been shown to grow at about seven to eight percent per annum. This generally accepted figure is derived from adding forecast economic growth to the inflation rate to get nominal GDP growth and then adding dividend returns.
GDP can be expected to grow at an annual rate of about three percent over the long term, and inflation of two to three percent, would push nominal GDP growth to five to six percent. In the long term, a diverse portfolio of equities should rise at that rate and dividend payments will boost total returns to seven to eight percent.
The table below shows how increasing investment returns reduces the percentage of the annual increase in gratuity liability that the employer needs to fund.
The total expense ratio (TER) of a gratuity scheme is a key measure. By far the largest component of the TER is investment management and associated fees. Investment management fees have a compounding impact on the value of the assets of the scheme. In other words, a gratuity scheme doesn’t just pay the fees, its value is reduced by the lost growth in subsequent years on the excessive fees.
For example, if the scheme invested AED5m, and the investments grew by six percent a year for 15 years and had no annual costs, it would be worth about AED12m. In contrast, if the scheme suffered annual costs of two percent it would only be worth AED9m – a 25 percent reduction in total value.
Professional gratuity scheme administrators can use their institutional buying power to negotiate lower fees for their clients. In our experience, the TER of a scheme should be less than one percent and the larger schemes have TERs of 0.7 percent or less. Lower TERs mean the scheme assets grow quicker and the employer can make lower contributions or increase the benefits payable.
By taking a long-term view of their gratuity liabilities, an employer can significantly reduce the cost of funding them and at the same time provide security for their employees. If an employer is willing to implement a more creative gratuity funding solution, they can motivate and retain key members of staff.