Determining Salary Growth Rate

Determining Salary Growth Rate

Salary growth rate is one of the most important assumptions used in valuation of employee benefits (e.g. gratuity, leave etc). The importance of the same is underscored by the sheer sensitivity of the liability to a change in this assumption (a 1% increase in assumed salary growth rate,say from 7% p.a. to 8% p.a., can easily result in an increase in liability by about 10%).

As per para 84 of the Accounting Standard 15 (Employee Benefits), assumption of salary growth rate should take into account inflation, seniority, promotion and other relevant factors, such as supply and demand in the employment market. Whilst this statement gives a broad overview of various factors to consider, in this note we have tried to analyse the various components of salary growth rate and lay down a practical framework for determining the same.

Before we proceed further, it is important here to highlight that it is ultimately the responsibility (as well as the right) of the management of the reporting enterprise to determine the assumptions to be used in the valuation. The role of the valuing actuary is to advice the management of what can be appropriate assumptions. However, it does not dilute management’s responsibility (and also their right) to choose the assumptions to be used in the valuations.

Salary growth rate can be typically seen as comprising of three components:

1. Inflation Component: The most basic component of salary growth rate is the ‘cost-of-living’ increase given by an entity to its employees, which by definition is closely linked to the prevailing Consumer Price Inflation (CPI).

Consumer Price Inflation (CPI) Index is related to the bond yields (refer below table) and hence the discount rate. The following table shows comparison of average bond yields and average inflation ratesin India over last 10 to 30 years:

Source: Internet (investing.com, RBI and other sites providing historical economic data)

As the above table shows, the average CPI, over a long term, has been about 1% to 2% lower than the prevailing interest rates / bond yields. This is logical as for real interest rates to be positive in the economy, the inflation must be lower than the prevailing interest rates.

Based on above, a broad thumb rule of inflation component being about 1.5% to 2% lower than the discount rate can be established. In other words, if the discount rate is 8%p.a., the inflation component of salary growth rate can be taken to be about 6% to 6.5% p.a. Further, this implies that with an increase in discount rate should result in a consistent increase in the inflation component of the Salary Growth Rate and vice versa.

It should be noted that many studies have taken empirical and theoretical perspectives to analyse the relationship between nominal interest rates and inflation, which support the above arguments. For example, Irving Fisher postulated that the nominal interest rate consists of an expected “real” rate plus an expected inflation rate. The real rate of interest is determined largely by the time preference of economic agents and the return on the real investment. These factors are believed to be roughly constant over time, and therefore, a fully perceived change in the purchasing power of money should be accompanied by a one-for-one change in the nominal interest rate.