End of ser­vice ben­e­fits and IAS 19: The case of United Arab Emi­rates (U.A.E)

In­tro­duc­tion

Pen­sion funds are con­sid­ered, in terms of in­vestable as­sets, the biggest in­sti­tu­tional in­vestors on a world­wide scale. Out of 70 Tril­lion U.S. Dol­lars in­vestable as­sets man­aged by in­sti­tu­tional in­vestors, pen­sion funds in­vestable as­sets amount to 35 Tril­lion U.S. Dol­lars (Berke­laar, Misic and Stimes, 2020). Pen­sion funds can be ei­ther gov­ern­men­tal or cor­po­rate. The gov­ern­men­tal funds are sim­i­lar to the U.A.E cit­i­zens gov­ern­ment-man­aged pen­sion fund, while the cor­po­rate pen­sion funds are sim­i­lar to the funds man­aged by cor­po­rates on be­half of their em­ploy­ees. Typ­i­cally, cor­po­rate pen­sion funds act as an in­vest­ment ve­hi­cle that are funded by cor­po­rates to cover em­ploy­ees’ ben­e­fit oblig­a­tion. How­ever, this is not gen­er­ally the case in U.A.E. be­cause cor­po­rates cal­cu­late end of ser­vice ben­e­fit pro­vi­sions and gen­er­ally do not cre­ate a pen­sion as­set to cover those li­a­bil­i­ties. The U.A.E end of ser­vice cal­cu­la­tion for­mula is well known and ap­plied by cor­po­rates’ ac­coun­tants and ex­am­ined by the fi­nan­cial au­di­tors. In fact, end of ser­vice pay­ment is an im­por­tant fi­nan­cial con­sid­er­a­tion for ex­pa­tri­ate em­ploy­ees be­cause 6 in 10 U.A.E res­i­dents rely on their end of ser­vice gra­tu­ity pay­ment to fund their re­tire­ment (Haine, 2019a). On one hand, the mech­a­nism of con­tribut­ing to a fund that sup­ports em­ploy­ees’ end of ser­vice oblig­a­tion pro­vides em­ploy­ees with rea­son­able as­sur­ance re­gard­ing re­tire­ment pay­ment as com­pared to be­ing to­tally not funded. On the other hand, cor­po­rates that man­ages such pen­sion fund ve­hi­cle can take the ad­van­tage of this fund to re­tain tal­ented em­ploy­ees. This ar­ti­cle first dis­cusses the pen­sion fund and pen­sion fund types. Then, the ar­ti­cle dis­cusses the IAS 19 ac­count­ing re­quire­ment for pen­sion funds. There­after, the ar­ti­cle dis­cusses the cur­rent prac­tice in U.A.E with re­gards to pen­sion fund man­age­ment and ac­count­ing. The im­pli­ca­tions of pen­sion funds on em­ploy­ees and em­ploy­ers in U. A. E. are then dis­cussed and fi­nally the ar­ti­cle con­cludes with a sum­mary and rec­om­men­da­tion.

What is the pen­sion fund?

Pen­sion funds are in­vest­ment ve­hi­cles used by cor­po­rates and gov­ern­ments to en­sure that em­ploy­ees will ob­tain post-em­ploy­ment ben­e­fits upon re­tire­ment. Pen­sion funds have two plans in­clud­ing the de­fined ben­e­fit plan or the de­fined con­tri­bu­tion plan. The first type of em­ploy­ees’ post-em­ploy­ment plans is the de­fined ben­e­fit plan (DBP). This plan is a re­tire­ment ben­e­fit plan guar­an­teed by the spon­sor. For in­stance, cor­po­rates’ de­fined ben­e­fits pen­sion plans guar­an­tee con­tin­u­ous pay­ments to em­ploy­ees upon re­tire­ment. To achieve this ob­jec­tive, spon­sors cal­cu­late their DBP oblig­a­tion with the help of an ac­tu­ary and con­tribute cer­tain amounts to the pen­sion fund as­sets which are ex­pected to cover the plan oblig­a­tions. In fact, the spon­sor, un­der DBP, has the oblig­a­tion to fund the plan for any short­fall in the amount be­tween the oblig­a­tion amount and the as­set held by the plan. Usu­ally, spon­sors del­e­gate the re­spon­si­bil­ity of fund man­age­ment to a third-party ser­vice provider. The risk to the spon­sor is that the li­a­bil­ity promised is open-ended, in the sense that it is re­lated to many vari­ables linked to fu­ture events all of which are as­sumed by the ac­tu­ary in cal­cu­lat­ing the spon­sor oblig­a­tion. Those as­sump­tion usu­ally do not keep con­stant which ex­poses the funded sta­tus of the plan to change and may re­quire fur­ther con­tri­bu­tion by the spon­sor. The other source of risk to the spon­sor is the changes in the val­ues of the pen­sion as­sets which may also re­sult in fur­ther con­tri­bu­tion by the spon­sor. The ac­tu­ar­ial cal­cu­la­tion of the plan li­a­bil­ity in­clude as­sump­tion about dif­fer­ent vari­ables, in­clud­ing, among oth­ers, age of the work­ers, mor­tal­ity rate, em­ployee turnover, in­fla­tion and salary in­crease pro­jec­tions. The fund man­agers usu­ally adopt an as­set-li­a­bil­ity man­age­ment frame­work (or li­a­bil­ity dri­ven in­vest­ment ap­proach) such that the plan li­a­bil­ity is eco­nom­i­cally hedged by plan as­sets. Ac­cord­ing to this ap­proach fund man­ager first es­tab­lished the in­vest­ment pol­icy of the fund based on the un­der­ly­ing risk and re­turn ob­jec­tives as well as the fund spe­cial cir­cum­stances and con­straints. For in­stance, a pen­sion funds whose par­tic­i­pants are em­ploy­ees of younger age would be more ca­pa­ble to take fi­nan­cial risk ver­sus a fund whose par­tic­i­pants are close to re­tire­ment. The lat­ter fund re­quires more cash pay­ment to the re­tirees which is ex­pected to be sooner than the for­mer fund. The dif­fer­ence be­tween the fund as­set value and the fund li­a­bil­ity is called the funded sta­tus. For ex­am­ple, if the fund as­set value is less than the fund li­a­bil­ity, the fund has an un­der-funded sta­tus and vice-versa. The sec­ond type of em­ploy­ees’ post-em­ploy­ment plans is the de­fined con­tri­bu­tion plans (DCB). Un­der this plan the spon­sor re­spon­si­bil­ity is lim­ited to con­tribut­ing a spe­cific amount of money to the fund, while the in­vest­ment re­spon­si­bil­ity is shifted to em­ploy­ees. This means that em­ploy­ees are the in-charge of their in­vest­ments, while the in­vestor role is to su­per­vise that the wealth man­age­ment firm pro­vides proper ser­vices to the par­tic­i­pants. Nonethe­less, the em­ployee bears all the re­spon­si­bil­ity of which as­sets to in­vest as well as the re­sult of these in­vest­ment de­ci­sions. DCB plans are more at­trac­tive to em­ploy­ers be­cause they limit the em­ployer fi­nan­cial risks by hav­ing to con­tribute a spe­cific amount to the fund. At the same time, the DCB pro­vides the em­ployee the lib­erty to man­age their own fi­nan­cials. In fact, the trend in the past 20 years is to shift the pen­sion plans from (non-gov­ern­ment) DBP to DCB (Berke­laar et al., 2020).

How to ac­count for DBP and DCB un­der IAS 19?

The scope of IAS 19 (Em­ployee Ben­e­fits) ap­plies to all em­ployee ben­e­fits ex­clud­ing em­ployee share-based pay­ments which are ac­counted for un­der IFRS 2. In this ar­ti­cle, the dis­cus­sion is cen­tered around the post-em­ploy­ment ben­e­fits and does not dis­cuss the ac­count­ing for em­ploy­ees’ other ben­e­fits such as ab­sence leave, salaries and wages, over­time and med­ical ben­e­fits. IAS 19 re­quires en­ti­ties to rec­og­nize: a li­a­bil­ity when an em­ployee has pro­vided ser­vice in ex­change for em­ployee ben­e­fits to be paid in the fu­ture; and an ex­pense when the en­tity con­sumes the eco­nomic ben­e­fit aris­ing from the ser­vice pro­vided by an em­ployee in ex­change for em­ployee ben­e­fits. Fur­ther, post-em­ploy­ment ben­e­fits payable to em­ploy­ees are ei­ther clas­si­fied as DBP or DCB as de­scribed in the pre­vi­ous sec­tion (IFRS.org, 2020a).

The ac­count­ing for DCB, as one might ex­pect, is a straight­for­ward ex­er­cise, wherein the spe­cific amount due on em­ployer is rec­og­nized as an ex­pense with a cor­re­spond­ing li­a­bil­ity that is held on the state­ment of fi­nan­cial po­si­tion un­til set­tled. In case of ex­cess con­tri­bu­tions, such ex­cess is rec­og­nized as an as­set un­til uti­lized. On the other hand, the ac­count­ing for the DBP is not that easy; it re­quires to have an ac­tu­ary who should con­sider fu­ture vari­ables re­lated to the ben­e­fit earned by the em­ploy­ees at­trib­ut­able to the cur­rent and prior pe­ri­ods. This in­cludes as­sum­ing at each re­port­ing pe­riod, among oth­ers, how many em­ploy­ees will be in ser­vice upon re­tire­ment (turnover), what would be the salaries of the em­ploy­ees upon re­tire­ment (salary in­crease and in­fla­tion as­sump­tions), em­ploy­ees life ex­pectancy (mor­tal­ity as­sump­tion), and what is the rate to be used to dis­count the fu­ture oblig­a­tions to the pre­sent value (time value of money). To cal­cu­late the DBP li­a­bil­ity, the ac­tu­ary uses a method known as (Pro­jected Unit Credit Method). Ac­cord­ing to this method, one need to cal­cu­late the pre­sent value of the ben­e­fits at­trib­ut­able to em­ploy­ees due to ser­vices ren­dered in the cur­rent and prior pe­ri­ods. To pro­vide an ex­am­ple of the Pro­jected Unit Credit Method, as­sume that an em­ployee whose cur­rent salary is 20,000 AED and that the agreed-on re­tire­ment ben­e­fit set at 2% of the fi­nal salary at re­tire­ment. In ad­di­tion, as­sume that the ex­pected re­tire­ment date is in year 5 and that the dis­count rate used is 10% while the an­nual in­crease in salary is ex­pected to be 5% per an­num. Fig­ure (1) be­low shows the amount to be rec­og­nized in in­come state­ment as re­lated to the cur­rent ser­vice cost as well as the in­ter­est ex­pense re­lated to the un­wind­ing of the in­ter­est cost on the dis­counted li­a­bil­ity. In this ex­am­ple, prior ser­vice cost was not con­sid­ered. 

The amounts to rec­og­nize in profit or loss and Other Com­pre­hen­sive In­come (OCI) and the move­ments in the bal­ance sheet ac­counts re­lated to DBP, as re­quired by IAS 19, go as fol­lows: First, the amounts rec­og­nized in profit or loss in­clude the cur­rent ser­vice cost, past ser­vice cost, gain and loss on set­tle­ment and net in­ter­est. Cur­rent ser­vice costs re­late to the in­crease in plan li­a­bil­ity for ser­vices ren­dered by the em­ploy­ees in the cur­rent pe­riod, past ser­vice costs re­late to costs of ser­vices ren­dered in prior pe­ri­ods in case there was amend­ments in the plan that are ap­plied ret­ro­spec­tively (plan amend­ments and cur­tail­ments) , gain and loss on set­tle­ment re­late to any set­tle­ment for em­ploy­ees who agreed to leave the plan for a con­sid­er­a­tion, and fi­nally profit or loss rec­og­nizes a net in­ter­est amount that is cal­cu­lated on the net po­si­tion of the plan as­set mi­nus plan li­a­bil­ity. Sec­ond, the amounts rec­og­nized in OCI in­clude amounts re­lated to changes in ac­tu­ar­ial as­sump­tions and the net re­turn on plan as­set. These amounts are items that can­not be re­clas­si­fied sub­se­quently to profit or loss. Amounts re­lated to changes in ac­tu­ar­ial as­sump­tions rep­re­sent the ef­fects of re­mea­sure­ment of the plan as­set or li­a­bil­ity re­lated to the ac­tu­ar­ial change in as­sump­tions or changes in ac­tual events that dif­fer from ac­tu­ar­ial as­sump­tions, while the re­turn on plan as­sets re­late to the dif­fer­ence be­tween the fair value of the plan as­set at re­port­ing date mi­nus the value of the plan as­set at that date net of the in­ter­est charged to profit or loss cal­cu­lated on the plan as­set as dis­cussed ear­lier un­der in­ter­est ex­pense. A pos­si­ble source of in­ter­est rate to be used for dis­count­ing is the yield on a high-grade cor­po­rate bond with a ma­tu­rity sim­i­lar to ma­tu­rity of the post-em­ploy­ment plan.

Last el­e­ment of the re­quire­ment of the IAS 19 is how to ac­count for the plan as­set and li­a­bil­i­ties. The move­ment in plan as­set and li­a­bil­ity goes as fol­lows: First, the plan as­set move­ment in­cludes, the con­tri­bu­tions from the spon­sor, the in­ter­est charge, the ben­e­fits paid and as­set re­turns. The lat­ter is sim­ply the dif­fer­ence be­tween the fair value of the plan as­set at re­port­ing date and the book value of those as­sets at the same date. Sec­ond, the plan li­a­bil­ity move­ment in­cludes, the cur­rent and prior ser­vice costs, the in­ter­est cost, the ac­tu­ar­ial gains and losses and fi­nally, the ben­e­fits paid to em­ploy­ees. Con­se­quently, the net DBP as­set or li­a­bil­ity is rec­og­nized in the state­ment of fi­nan­cial po­si­tion. The recog­ni­tion of a net li­a­bil­ity po­si­tion is eas­ily un­der­stood be­cause the plan li­a­bil­ity is the spon­sor’s oblig­a­tion un­der IFRS. How­ever, the recog­ni­tion of an as­set is ques­tion­able as the as­sets are the prop­erty of the plan par­tic­i­pants. To an­swer this ar­gu­ment, one might re­fer to the IFRS frame­work which de­fines the as­set as an eco­nomic re­source con­trolled by the en­tity due to past events and from which the en­tity ex­pects to re­ceive fu­ture eco­nomic ben­e­fits. The net plan po­si­tion is an eco­nomic re­source con­trolled by the en­tity that re­sulted from past events and from which the en­tity ex­pected to re­ceive eco­nomic ben­e­fits in the form of re­duced con­tri­bu­tions. There­fore, the net plan as­set po­si­tion can be rec­og­nized on the state­ment of fi­nan­cial po­si­tion of the plan spon­sor.

What is the cur­rent prac­tice in U.A.E?

In U.A.E, the la­bor law states that the end of ser­vice ben­e­fits to em­ploy­ees starts if the em­ployee stays in ser­vice for more than one year and is cal­cu­lated based on cer­tain for­mula. This means that, the de­fined ben­e­fit plan in U.A.E does not pro­vide post-em­ploy­ment pay­ments dur­ing the re­tire­ment pe­riod, sim­i­lar to the re­tire­ment plans dis­cussed above, rather it pro­vides a lamp-sum amount at re­tire­ment. Nev­er­the­less, it is still sub­ject to the IAS 19 re­port­ing re­quire­ments. Un­der U.A.E la­bor law, the em­ployee end of ser­vice ben­e­fit is cal­cu­lated un­der two types of con­tracts, the lim­ited and the un­lim­ited. Re­gard­less of the type of the con­tract, the cal­cu­la­tion method­ol­ogy is the same, wherein the lat­est ba­sic monthly salary is used and the num­ber of days as a frac­tion of month are de­ter­mined based on num­ber of years in ser­vice. For in­stance, an em­ployee who stays in the com­pany for more than 5 years, is on un­lim­ited con­tract and was ter­mi­nated by the em­ployer. This em­ployee is el­i­gi­ble for 30 days of the lat­est ba­sic monthly salary for each year of ser­vice above 5 years. In ad­di­tion, the same em­ployee is el­i­gi­ble to 21 days of the lat­est monthly ba­sic salary for the first five years. An­other ex­am­ple is an em­ployee who has 2 years of ser­vice, is on lim­ited con­tract and the em­ployee re­signs. Then, this em­ployee is el­i­gi­ble for 21 days of the lat­est ba­sic monthly salary for each year of ser­vice (UAE of­fi­cial gov­ern­ment web site, 2020). Com­pa­nies cal­cu­late the so called (End of Ser­vice) pro­vi­sion and may or may not con­sider time value of money. This pro­vi­sion is re­ported as a long-term li­a­bil­ity on the state­ment of fi­nan­cial po­si­tion. If one sur­veys the fi­nan­cial state­ments of the com­pa­nies listed on DFM or ADX, one would find three types of treat­ment based on the au­thor ob­ser­va­tion. First treat­ment is a full com­pli­ance with IAS 19 by as­sign­ing an ac­tu­ary and cal­cu­lat­ing the plan li­a­bil­ity. Sec­ond treat­ment is by per­form­ing an as­sess­ment of the ma­te­ri­al­ity of the dif­fer­ence be­tween the end of ser­vice pro­vi­sion and the DBP oblig­a­tion based on cer­tain as­sump­tions of salary in­crease and dis­count rate. Usu­ally the de­ci­sion is that no ma­te­r­ial dif­fer­ence ex­ists and no fur­ther dis­clo­sure is pro­vided. The last type of treat­ment is the other ex­treme where the re­port­ing en­tity does noth­ing with re­gards to the DBP as per IAS 19 re­quire­ments. Ex­ter­nal au­dit firms au­dit­ing these fi­nan­cial state­ments seem to agree on the treat­ment as no qual­i­fi­ca­tions are men­tioned in their au­dit re­ports. By the same to­ken, IFRS Foun­da­tion in a pub­li­ca­tion re­gard­ing the IFRS ap­pli­ca­tion around the world in 2016 men­tioned that, in U.A.E, the cur­rent prac­tice men­tioned above is ac­cepted as the dif­fer­ence is im­ma­te­r­ial, how­ever, this prac­tice is not in com­pli­ance with IAS 19 (IFRS.org, 2020b).

What are the im­pli­ca­tions of the DBP cur­rent prac­tice in U.A.E on em­ploy­ees and em­ploy­ers?

The em­ploy­ers in U.A.E gen­er­ally are not fund­ing their li­a­bil­i­ties and they are con­sid­er­ing the fund­ing to take place on a case-by-case ba­sis i.e. when the em­ployee re­signs or made re­dun­dant, the em­ployer pays the re­lated end of ser­vice. This prac­tice has two draw­backs. First draw­back is on the em­ployee side be­cause ex­pa­tri­ate em­ploy­ees serv­ing com­pa­nies in U.A.E may find it dif­fi­cult to get their ben­e­fits paid if the em­ployer goes bank­rupt or does not have the proper liq­uid­ity to set­tle the em­ployee ben­e­fit upon re­tire­ment. The em­ploy­ees also may not be able to de­fend their rights if the em­ployer un­rea­son­ably deducts some amount of the em­ployee end of ser­vice for which it is dif­fi­cult for the em­ployee to de­fend due to time and cost (Haine, 2019b). The sec­ond draw­back is on em­ploy­ers who are us­ing short-term cap­i­tal to fund long term li­a­bil­i­ties and also risk­ing their rep­u­ta­tion in case they have liq­uid­ity is­sues and they were not able to set­tle em­ployee end of ser­vice ben­e­fits on time.

Con­clu­sion and rec­om­men­da­tions

Pen­sion plans are great tools to pro­tect em­ploy­ees’ fu­ture ben­e­fits upon re­tire­ment and to help em­ploy­ers man­age their liq­uid­ity and em­ployee oblig­a­tions. This type of funds is the biggest in­sti­tu­tional in­vestors on a global scale whose pri­mary ben­e­fi­cia­ries are plan par­tic­i­pants. The ac­count­ing for these em­ployee ben­e­fits is con­trolled by the IAS 19. The ac­count­ing and re­port­ing un­der this stan­dard with re­gards to the DCB is sim­ple, while the ac­count­ing for the DBP is com­plex and re­quires a lot of as­sump­tions. Com­pa­nies op­er­at­ing in the U.A.E are man­ag­ing DBP un­der the la­bor law re­quire­ments and they don’t not fund the li­a­bil­i­ties up­front, rather they fund it on the case-by-case ba­sis. The re­port­ing en­ti­ties’ treat­ments are dif­fer­ent and in­clude three ap­proaches by ei­ther to fully com­ply with the IAS 19 re­quire­ments, mid-way com­pli­ance by stat­ing that the dif­fer­ence be­tween end of ser­vice pro­vi­sions and the IAS 19 DBP li­a­bil­ity is im­ma­te­r­ial or, fi­nally, by be­ing fully in­com­pli­ant. The au­thor be­lieves that al­though it is un­der­stood that smaller com­pa­nies with lower prof­its and la­bor force size might not be in­clined to per­form the IAS 19 re­quired cal­cu­la­tion due to cost con­sid­er­a­tions, the com­pli­ance of larger com­pa­nies should be more ro­bust. H. H. Sheikh Mo­hammed Bin Rashid Al Mak­toum en­acted an Em­ploy­ment Law Amend­ment No. 4 of 2020 that re­quires a De­fined Con­tri­bu­tion Plan on em­ployer reg­is­tered in the DIFC (Al Khaleej Times, 2020). The au­thor be­lieves that this law amend­ment is a great so­lu­tion for the em­ployee ben­e­fits in U.A.E and com­plies with the cur­rent trend world­wide as dis­cussed ear­lier. This so­lu­tion pro­tects the em­ploy­ees’ rights while re­duces the em­ployer fi­nanc­ing and ac­count­ing bur­dens.

Ref­er­ences

• Al Khaleej Times (2020) Sheikh Mo­hammed en­acts new gra­tu­ity law in Dubai, Al Khaleej Times, web ar­ti­cle, avail­able at: https://​www.​kha​leej​time​s.​com/​uae/​dubai/​sheikh-​moh​amme​d-​enacts-​new-​gra​tuit​y-​law-​1, [ac­cessed on 20 July 2020].
• Berke­laar, A., Misic, K and Stimes, P, C (2020) Port­fo­lio Man­age­ment for in­sti­tu­tional in­vestors, CFA Level III re­fresher read­ing, p.p. 1-106.
• Haine, A (2019a) Six in 10 UAE res­i­dents rely on their gra­tu­ity to fund their re­tire­ment, Web ar­ti­cle, Busi­ness, avail­able at: https://​www.​the​nati​onal.​ae/​bus​ines​s/​money/​six-​in-​10-​uae-​res​iden​ts-​rely-​on-​their gra­tu­ity-to-fund-their-re­tire­ment-1.815925, [ac­cessed on 20 July 2020].
• Haine, A (2019b) The UAE’s gra­tu­ity sys­tem is in line for a shake up, Web ar­ti­cle, Busi­ness, avail­able at: https://​www.​the​nati​onal.​ae/​bus​ines​s/​money/​the-​uae-​s-​gra​tuit​y-​system-​is-​in-​line-​for-​a-​shake-​up-​1.​827901, [ac­cessed on 20 July 2020].
• IFRS.org (2020a) IAS 19 Em­ployee Ben­e­fits, avail­able at: https://​www.​ifrs.​org/​issued-​sta​ndar​ds/​list-​of-​sta​ndar​ds/​ias-​19-​emp​loye​e-​ben​efit​s/, [ac­cessed on 20 July 2020].
• IFRS.org (2020b) IFRS ap­pli­ca­tion around the world, Ju­ris­dic­tion pro­file: United Arab Emi­rates, avail­able at: https://​cdn.​ifrs.​org/-/​media/​feature/​around-​the-​world/​jur​isdi​ctio​n-​pro​file​s/​united-​arab-​emi​rate​s-​ifrs-​profile.​pdf, [ac­cessed on 20 July 2020].
• UAE gov­ern­ment web site (2020) End of ser­vice ben­e­fits for em­ploy­ees in the pri­vate sec­tor, avail­able at: https://​u.​ae/​en/​inf​orma​tion-​and-​ser​vice​s/​jobs/​end-​of-​service-​ben​efit​s-​for-​emp​loye​es-​in-​the-​private-​sector#:~:text=An%20em­ployee%20who%20has%20spent,the%20ter­mi­na­tion%20of%20his%20ser­vice.&text=If%20an%20em­ployee%20has%20served%20­for%20­more%20than%201%20year,for%20each%20year%20of%20­work. [ac­cessed on 20 July 2020].