Understanding End-Of-Service Benefits In The UAE
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It’s often said that nothing is certain, but for businesses in the UAE one thing that is certain is the need to provide end-of-service benefits -also known as ESBs, gratuities or termination indemnities- to employees when their employment terminates.
End-of-service benefits are envisaged by the local labor law in the UAE, as well as by the labor laws in all other Gulf countries, but widely misunderstood by the business community. Since 2010, Willis Towers Watson has been surveying up to 250 companies in the Middle East, to help better understand this issue. And the results from the most recently published survey are quite worrying. We observed a definite increase in the size of ESB liabilities compared to 2015, with around one-fifth of companies now facing liabilities of over US$ 15 million. Therefore, many businesses need to get their ESB liability exposures valued (so they are understood) and preferably funded or part funded via a sustainable long-term solution– it’s not only important for a healthy business, but also for the workers who rely on them.
Let's take a closer look at what ESBs are and why they’re causing so much concern. We focus here on the UAE as our example to highlight.
The UAE Labor Law, Article 132
A worker who has completed one or more years of continuous service shall be entitled to severance pay at the end of his employment. The law goes on to state that the total amount of severance pay should not exceed two years’ worth of wages. The lump sum that’s owed is calculated using the following: 21 days' wages for each of the first five years of service, plus 30 days’ wages for each additional year of service.
Converting this into an approximate percentage of wages perhaps makes it easier to understand and compare. Assuming annual wages are paid on a 365-day basis, in the first five years, employees are due around 5.8% of their wages (so this being the normal regular wage) for each year’s service. After this, it jumps to 8.2%. As a simple illustration, if you assume a constant wage, the two-year cap means you can work for around 25 years before you stop accruing rights to the benefit.
This law has been in place in the UAE for over 35 years, but it still brings with it many challenges for employers. Historically, with a workforce that is mostly expatriate, organizations in the Gulf have often struggled to retain staff. But according to the soon-to-be-published Willis Towers Watson Middle East ESB survey 2017, including responses from 246 companies, this may be changing. When asked to estimate how long on average they expected workers to stay, only 2% of those surveyed said one to two years. Nearly 60% expected employees to stay five years or more, thereby slowly accruing ESBs during that time. And, of course, it is the employees who quietly amass many years of loyal service, who end up generating the greatest financial liabilities and creating potential challenges for the employer.
What’s more, a large number of companies are not funding their ESB liabilities, either in whole or in part. In the Willis Towers Watson Middle East ESB survey 2017, as many as 88% of organizations across the Middle East had no sustainable plan in place to fund their exposure, choosing instead to settle when due and make the payments out of current profits or reserves.
But what if there are no profits, or the company comes under severe financial pressure? A bad year can substantially impact a company’s ability to pay these labor law obligations.
Put all this together and you have what I refer to as the ‘good time, long time’ effect. Let’s imagine a UAE company enjoys a decade of growth. During these good times, it grows from 200 to 2,000 employees. It pays its staff well, offers a great benefits package and people are keen to stay for a long time. But then there is a downturn. Customers start pulling back their business. Profits tumble. And the employer has no option but to cut staff. But with no funding plan in place it has to pay the ESBs for the terminated staff directly from its current reserves.
It’s a Catch-22. At precisely the moment it faces cash-flow problems due to the worsening business climate, it may also face a high level of ESB payouts due to its necessary staff cuts.
Even those sensible companies that do place money into a special fund can hit a snag when they come to pay, because they set aside funds based on the worker’s starting wages, not necessarily final wages. Some companies face substantial cash shortfalls when it comes to ESB settlement, unless they have adjusted their contributions to take account of increases in employee pay over time. And getting paid isn’t the only problem employees face.
Into the unknown
For most expatriate workers, the supplementary occupational retirement plans or personal pensions that exist in their native country are either non-existent or poor value in the UAE and wider GCC. Hence, many are relying on the ESB. However, many have a poor appreciation of the true value of the benefit, as well as the effect that changing employers could have.
As we saw earlier, ESB is based on employer contributions only, as a percentage of normal wage, and the target contribution rate for this each year is around 5.8% and 8.2% of normal wage, depending on service, (although a high proportion, 40% according to the Willis Towers Watson Middle East ESB Survey 2017, also do provide enhancements to the minimum required ESB payments).
This pales in comparison to defined contribution pension plans elsewhere, which often can involve contributions from both employers and employees. Take the UK as an example: in Willis Towers Watson’s 2017 survey of FTSE-350, when asked to define contribution pension schemes, for some companies, it is where employee contributions and matching are included, see up to 16.5% of basic pay invested into a UK pension plan. The amount employees are owed can also be reduced if they switch employers, especially if they move frequently of their own accord. Not only are they stuck beneath the lower ESB threshold, they also forfeit a percentage of ESB by choosing to resign. In the UAE, for example, Article 137 of the Labor Law states that if someone is employed for three years or less and leaves on their own initiative, they are entitled to just 1/3 of their ESB.
A lack of transparency is also hindering workers. Those who receive a basic salary plus certain allowances -say bonuses, housing or healthcare– may find that their ESB payment turns out to be less than they expect. Some fail to realize that the ESB is calculated on the basis of normal wage alone and typically ignores certain added extras, such as irregular payments and certain allowances.
A shining light
A more sustainable approach to ESBs is, therefore, required in the UAE. That much is clear. But how to do it? Below I take you through a few solutions that would help businesses manage their liabilities better, and assist employees in improving their longer term savings potential.
Account for it When the Willis Towers Watson Middle East ESB survey 2017 asked respondents how they intended to account for the payouts, 4% had no idea while the majority, 65%, said via local books, and only 19% pointed to the global accounting standard for this kind of liability, known as International Accounting Standard (IAS) 19. This form of accounting requires the company to disclose the long-term cost of these employee benefit schemes, including ESBs, on their yearly accounts, and was made mandatory in the UAE as of July 2016 for certain companies.
Separate it Since 2013 there has been little movement in the proportion of companies funding their ESB via external vehicles, away from the company balance sheet– the figure has remained at around 15% from 2013 to 2016, with only minor fluctuations along the way. This needs to change. Ongoing funding of the benefit via a segregated trust (or contract) would place ESBs more squarely in line with western style pension schemes. According to the Willis Towers Watson Middle East ESB survey 2017, of those who do invest in external funds, 26% do so in an insurance company product and 37% use a simple bank deposit. Only 11% go direct to an asset manager. Either way, using an external fund not only safeguards the money but allows both employers and employees to make use of Article 141 as explained below.
Enhance it Under Article 141, a worker can choose a different retirement plan (such as a pension) over an ESB if it is advantageous. The expatriate nature of the Gulf workforce makes it difficult to offer a traditional pension scheme, but nothing stops a company providing something similar. Namely, for example, a trust into which both the employer and employee pay on a monthly basis in line with ESB rules, allowing the worker to save more for retirement if they so choose. Offering an enhanced ESB is an increasingly popular strategy in the UAE, especially as it helps to both attract and retain skilled staff. The Willis Towers Watson Middle East ESB survey 2017 survey found that 40% of organisations now provide enhanced ESBs, and of these, a separate defined contribution savings plan was the most popular option, being implemented by 63% of respondents who chose to enhance the ESB.
Regionalize it Another viable way to potentially enhance ESBs is to offer a regional solution. Many employees move between Gulf countries but stay at the same company, or at least within the same group. Allowing them to carry forward their ESB on a job move internally, rather than resetting it each time they move, could have a positive impact on loyalty and reduce the risk of losing talent to competitors, as well as more fairly rewarding the hardworking, loyal employee, driven by retaining the link to an increasing normal wage and loyal service.
The future is bright
For many businesses in the GCC, ESBs are a big problem that could get a whole lot worse. But both governments and businesses are beginning to act. Taking action and getting it right will not only benefit the long-term health of our companies, but also the long-term future of our workers.