UAE – A SOLUTION TO END OF SERVICE PROBLEM

Introduction

The End of Service Gratuity or End of Service Benefit (“EOSB”) is nothing new and has been entrenched in UAE Labour Law for several years. However, from 1 July 2016, UAE companies were required to prepare their financial statements in a manner compliant with IAS-19. This standard prescribes the accounting treatment and disclosure for employee benefits and given that the EOSB constitutes a defined benefit post-employment plan, the relevant employee liability must be shown in the income statement, balance sheet and the Notes.

While companies will be forced to adopt the correct accounting procedure, the concerning aspect continues to be the fact that most are not funding these liabilities. Peter Cox, Head of International Pension Plans at Zurich in the Middle East stated that, “The EOSB dilemma is an inconvenient truth. Although 83% of companies don’t fund their EOSB liabilities, 85% think it would be a good idea if they did”.

There is no rational financial, accounting or business reason not to do this. Research conducted by Willis Towers Watson concluded that the combined EOSB liabilities in the GCC could increase to US$ 75 billion by 2020. Further, foreign workers are staying longer in Dubai – various surveys indicate that the average stay is increasing from 4.5 years to almost 7 years – this increases the EOSB liability.

So, given the magnitude of the amounts mentioned above and the plethora of vehicles available, such as an International Pension Plan, why is the liability not being funded? Quite simply - because there are no legislative regulations to enforce this. The EOSB liabilities are currently used to fund the company’s working capital!

Calculation of the EOSB

The EOSB is a relatively simple concept. The UAE Labour Law states that it is payable to all employees at the end of their service irrespective of whether they resign or if their services are terminated. The pay-out calculation for the EOSB in respect of resignation, mutual agreement of separation or retirement for an unlimited employment contract, is relatively simple:

Payout Methodology - Axiomatic Consultants

Basic Salary is defined as basic pay but excluding allowances such as housing, transport, travel, overtime, schooling, club fees or any other bonus or allowances. Cognisance must be taken that the calculation methodology in the case of an employer termination is different.

The pay-out profile for an employee earning a Base Salary of AED 120,000 per annum would be:

End of Service Benefit Payout Profile - Axiomatic Consultants

What is immediately obvious is that the pay-out profile is not linear and significant “jumps” are experienced in the 3rd and 5th year of service.

End of Service Benefit Payout Profile

There is an additional problem when calculating the EOSB, namely that the Base Pay used for the calculation is the last wage the employee received when they leave the company. This significantly increases the actual pay-out profile as demonstrated in Table 3 below, where we have assumed that the employee receives a consistent 5% salary increase each year:

End of Service Benefit adjusted pay-out profile

Table 3 clearly shows that if one assumes the employee will receive a 5% annual salary increase, the Pay-Out increases significantly.

The EOSB is thus relatively simple to calculate and one must therefore ask the question why most companies do not fund this liability but rather elect to pay out the full amount from working capital when the employee leaves?

The reason may be attributable to the non-linearity of the calculations. In Table 4 below, we have assumed the Adjusted Base Salary from Table 3 and then calculated the annual accrual which the company should provision – one can clearly observe the wide distribution of accrual percentages over the 7-year period:

Annual Accual Based On Adjusted Salary

 

In the 1st year of employment, the company must provision 1.94% of the employee’s Base Salary, in the 2nd year 2.04%, while in the 3rd year this leaps to 7.96%, only to fall dramatically to 4.44% in the 4th year.Hardly a funding policy which an accountant would embrace!

However, cognisance must be taken of the fact that such accruals would have to be made in the financial statements. From the company’s perspective, this is the correct, prudent and fiscally responsible funding policy which should be adopted to prevent significant costs being incurred in a year where several long serving employees leave the company.

Impact on employees

If we now shift the focus of our attention to the employee. The simple average percentage paid to the employee amounts to approximately 7.50% per annum over the 7-year period; hardly sufficient to achieve a target of a 70% replacement ratio at retirement!

However, of significant importance is the fact that the employee does not derive the benefit of compounding returns - the amount of the EOSB is not compounded periodically as would be the case if the amounts were deposited into an interest-bearing account.

Further, the employee does not have the opportunity to enjoy any capital gains; the chart below shows the gains of the Dow Jones Industrial average over the last 7 years. Over the period the Dow has increased by 149.5% or an annualised return of 13.95%. Clearly, the “opportunity loss” for the employee is that they would not have benefited from the significant capital gains had they invested in equities:

Growth Diagram - Axiomatic Consultants

Solution

There is a relatively simple solution to the problem – one that will suit the accountants, employees, the company and all stakeholders.

Axiomatic can assist you to set up an appropriate International Pension Plan (“IPP”) for your foreign workers and manage, for and on your behalf, the annual contributions to be made to the plan to ensure the EOSB liability is fully funded.

Further, the Axiomatic solution would allow your employees to make voluntary contributions. Retention is becoming a critical issue in Dubai as discussed in our recent article (http://www.axiomatic.co.za/news/talent-retention-uae/). The implementation of such an IPP would not only act as an effective retention mechanism but would also improve your company’s standing as an Employer of Choice in the local market.

For more information please contact Brett Hopkins on +27 11 305 1945 or brett@axiomatic.co.za