Salary escalation rate calculation

Quick snippet

While calculating salary escalation rate assumption for actuarial valuation, we should consider all sources of salary increments, including promotions.

This exercise can become quite tedious, however, we suggest a simpler solution by using the following formula:

Salary escalation rate = Salary at end of the year /  Salary at start of the year

We discuss below the importance, approach, formula and potential pitfalls to avoid while calculating this assumption for AS15 and IndAS19 actuarial reports.

The Importance

Salary escalation rate is one of the most important assumptions used in actuarial calculation of liabilities as per Indian accounting standards AS15 and IndAS19. We may argue that its significance is secondary only to the discount rate assumption. It impacts the value of the future cashflow projection directly.

A higher salary escalation rate results in higher future salaries. As per gratuity and leave encashment schemes, the amount payable to an employee upon exit is, generally, a factor of the salary at that time. Thus, a higher salary will result in a higher cash outflow at the time of exit of the employee. This, in effect, translates to higher liability amounts for higher salary escalation assumption and vice-versa.

Methodology 1

Expert Judgment

There are a few approaches to estimate the salary escalation assumption.

The simplest approach relies on the management view of the future planned salary increments and promotions. For instance, management may decide salary escalation to be 10% based on following calculation:

  • Annual inflation increment: 5%
  • Annual promotion increment = 20% x 20% = 4%, based on
    • 20% of employees get promoted every year on average
    • 20% is the average increase in salary upon promotion
  • Other ad-hoc / performance related increments: 0.5%

Methodology 2

Historical Average

However, such foresight might not always be available. Also, we may decide that future salary increment is expected to be similar to the past experience. In that case we can use the following methodology:

  1. Calculate salary escalation rate for each of the historical years using formula:

    Salary escalation rate = { Total salary at end of the year /  Total salary at start of the year } -1 

  2. Please make sure you are excluding any new joiners and exiting employees from the above calculation
  3. Exclude any outlier years, say where increments were too low (or high), maybe due to pandemic, for instance.
  4. Take an average of the annual salary escalation rates
  5. Adjust for future expected events, trends, business plans and strategy.

Methodology 3

CAGR

CAGR stands for Cumulative Annual Growth Rate in salary (in this case). This approach is slightly more complex mathematically. As an actuary, we would like to say that this is the most suitable approach, however, this might not always be pragmatic. However, if we have low attrition rates and more or less a stable workforce, then this approach might give us the most appropriate estimate. Formula is as follows:

For a DMT (time period) of say 5 years:

Salary escalation rate = { ( Total salary at end of 5 years /  Total salary at start of 5 years ) ^ ( 1/5) } -1

And once again, we must be careful to exclude the new joiners and exits from both start and end while considering the total salary.

Categories

But what if my company’s salary increments varies by categories of employees?

Fret not! We’ve got you covered. In the above methodologies, you can calculate salary increment for each category. In the formulae above, please take the total for the respective category and apply the same methodology, as preferred.

In our software, we have provided the option to input salary escalation assumption for each category. You then simply need to map each employee to one of the categories. Watch our tutorial YouTube video on how to do this by clicking here.

Checklist

  • We are calculating attrition rate for the future, not the past.
  • Given the above, we should strive to keep the attrition rate consistent with future business plans and strategy.
  • Allow for future trends such as change in inflation, etc.
  • We have to calculate the attrition rate as ‘forward-looking’ ‘time-average’ over a long-term
  • As already mentioned above, we should strive to keep salary escalation assumption consistent year-on-year, unless company’s view of future attrition rate has changed significantly
  • It is important for you to understand the requirements of AS15 and IndAS19. Our actuary can help you if you are not sure about these over a call.
eb@itactuary.com
+91 80 4568 1111