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Gratuity pay outs: How to protect your business from a nasty surprise

May 20, 2018

Failing to prepare for gratuity payouts could be disastrous for a company in the UAE. Yet many business managers in the Emirates don’t fully understand gratuity, let alone have a plan in place to save money for future payouts.

The internationally mobile nature of the UAE workforce adds to the challenge. Nobody wants a good employee to leave, but being unprepared for their departure doesn’t just mean having to find replacement talent. It could create serious cash flow problems if money hasn’t been set aside for a potentially substantial payout.

To avoid the pitfalls and protect your business, it’s important to understand how much it costs, how to save for future payouts, and the alternative options available.

What’s the cost of gratuities to your company?

End-of-service gratuity (ESG) is a statutory severance pay in the UAE and other Gulf countries, similar to retirement savings or pension scheme. The calculation is applied to the employee’s salary at the time of termination, which can result in the ESG being a substantial payout for long-serving employees.

End-of-service gratuity (ESG) is a statutory severance pay in the UAE and other Gulf countries, similar to a retirement savings or pension scheme.

Let’s look at an example.

Assume an employee resigns from an unlimited contract, after two years’ service, with a basic salary of AED 15,000 per month. The company would have to pay around AED 10,500 (21 days’ pay) multiplied by x2 (the number of years in service) but reduced by two-thirds: a total of around AED 7,000.

Now assume that same employee resigns after exactly five years’ service, on the same salary (AED 15,000 per month). The gratuity payout in this case would be around AED 10,500 multiplied by x5, with no reduction: a total of around AED 52,500.

After more than five years of service, the payout would be even higher, based on 30 days’ pay for each additional year beyond five years’ service. In total, however, the entire compensation payment cannot exceed two years’ pay: AED 360,000 using the employee in the above example.

It’s worth noting that the other five countries in the Gulf Cooperative Council (GCC) – Saudi Arabia, Bahrain, Kuwait, Qatar, and Oman – operate similar ESG models for their non-national workforces. The calculation and specific conditions of the termination payments vary from country to country. But according to law firm Al Tamimi and Co, the combined ESG liability of all employers operating in the GCC is estimated at more than AED 54.75bn (USD 15bn).

Yet – despite the eye-watering numbers – many business managers in the Emirates don’t fully understand gratuity, let alone have a plan in place to save money for future payouts.

How to prepare for gratuity payouts

The vast majority of companies in the UAE pay ESG from working capital, which can result in cash flow problems in the event of a large or unexpected payout.

CIPD, the professional body for HR and people development, says that one of the reasons ESG is seen as high-risk is because many businesses keep employees’ gratuities in the corporate bank account and use the money as working capital until it is due to be paid – which means the risk of an organisation not having access to the gratuity when it is required is very real.

Those employers who plan their gratuity liabilities often set aside a cash reserve in a separate bank account. And rather than leaving these gratuity reserves sitting on the company balance sheet, it is also worth considering some kind of gratuity plan to invest the reserves separately. The idea is that the investment plan earns returns over time, while simultaneously being used for gratuity payments upon employee exit if needed.

Those employers who plan their gratuity liabilities often set aside a cash reserve in a separate bank account.

Failing to ring-fence the gratuity funds in this way exposes the company to potential credit, legal, operational, business and reputational risks. Louvre Group notes that, to fund the liability, best practice would suggest the company place its gratuity funds with a third party held to the company’s order: ‘Together with the annual evaluation, this should ensure that funds are held, invested suitably and retained for the employees, and not utilised as working capital of the business.’

Al Tamimi and Co take the same view, claiming that it would be prudent to consider setting aside a sum equivalent to approximately 8% of the company payroll each year. This is equivalent to a 13th month of payroll, ensuring that ESG liability can be met on an ongoing and sustainable basis.

Alternatives to paying ESG

Investing gratuity reserves seems a sensible option but it is not the only one available to employers.

First, employers can provide a pension scheme for non-national employees, which is more beneficial than they would otherwise receive under the ESG model.

Any such scheme must be published and known to all employees, and must specify that it is a substitute for the ESG. Also, the employees must agree and acknowledge that it will be paid to them in place of the ESG: if not, the employee will be entitled to both the pension and the ESG. As employers are not legally obliged to provide this alternative for non-national employees, the majority of private employers have opted not to put in place pension schemes of this kind.

Second, they can register UAE national employees into the state pension scheme and accordingly pay pension contributions to the General Pensions and Social Security Authority. National employees are subsequently entitled to draw a pension when they reach retirement age. National employees in both the private and public sectors are usually registered with the state pension scheme. But where they are not, they are also entitled to an ESG payment on termination.

Employers who find these ESG alternatives too complex may decide instead to take the route of strategically investing gratuity reserves.

The end of ESG?

Against this backdrop, the UAE Government is said to be considering alternatives to the current system. As far back as 2011, the Economist reported that the Dubai Department of Economic Development was working with the World Bank on ways in which employment laws in the emirate might be improved.

The ideas are still at the proposal stage, but if implemented could lead to employers being asked to contribute around 8% of an employee’s basic salary to a pension scheme. Employees would receive pension payments following the termination of employment.

The ideas are still at the proposal stage, but if implemented could lead to employers being asked to contribute around 8% of an employee’s basic salary to a pension scheme.

There are both pros and cons of making a change like this. It’s worth remembering that even where pension schemes or contribution systems are permitted, a pension can be difficult to administer in a country like the UAE because of the transient working population and the fact that many workers will eventually return to their home country.

Either way, with so much at stake, companies in the UAE should consider seeking expert advice about their ESG situation. At the very least, a plan should be in place to save money for future payouts, and companies should be considering the merits of both investing in gratuity plans and enhancing their benefit schemes in other ways.

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About the author: Chris Kendrick, UAE Commercial Director

Chris Kendrick is a financial services professional with 17 years of experience across multiple disciplines including private banking, SME banking, retail banking and offshore financial planning, He has worked for some of the world’s leading financial institutions in the UK and UAE, including Standard Chartered Bank, HSBC, and NatWest. Chris started with Lifecare International as the Head of Private Clients transforming the business to a client centric fee based adversary. Chris is now the UAE Commercial Director for
Lifecare looking after all Wealth, Medical and Insurance businesses.