Impact of a Pay-cut on Your Retirement Income

Jun 24, 2020

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Various companies and businesses are having a tough time sustaining in the current situation due to nationwide lockdown to curtail the spread of the coronavirus. Opening up in a phased manner is slow because COVID-19 cases continue to rise.

Meanwhile, some of the companies have had layoffs and/or salary cuts for employees. It is truly a grim situation, as it hurt the income drastically. With a cut in salaries, not only did the net take-home drop, but also so did their retirement savings.

The salary component comprises of various other heads like provident fund and gratuity, which are generally seen as retirement kitties. Both these are calculated based on the basic salary and dearness allowance and when employers administer a pay cut, these benefits are impacted as well.

Private sector organizations have a salary structure that is based on the cost-to-company (CTC) structure, so in case of a salary cut, each of the various heads (PF, HRA, and gratuity) of salary are revised on a proportionate basis because the pay cut is implemented across the board. Thus, the retirement savings take a hit indirectly.


(Image Source: Image by Gerd Altmann from Pixabay)

Let's understand how it impacts retirement savings.

Effect on EPF savings

As per the Employees' Provident Fund and Miscellaneous Provisions Act, employees have to contribute 12% of their basic wage plus dearness allowance towards PF. An equivalent contribution of 12% is made by the employer as well.

Suppose a person has a basic salary plus dearness allowance of Rs 25,000, then his monthly contribution towards PF will be Rs 3,000 and with an employer's contribution, it will add to Rs 6,000.

Now, when a person's salary is cut by 18%, the basic pay plus dearness allowance in the above-mentioned scenario will go down to Rs 20,500 and the PF contribution will drop to Rs 4,920 per month. This low PF contribution will eventually affect the retirement savings of the person.

Assuming the person is age 40 and has 20 years of service remaining, the initial retirement corpus of Rs 3,788,641.16 drops to Rs 3,106,685.75 after the salary cut. The person suffers a loss of Rs 6,81,955.41 in the retirement kitty, assuming a rate of interest of 8.5% on PF throughout the remaining service period..

Table 1: How the salary cut affects the EPF corpus
Original salary(Rs) 25,000
EPF before pay cut at 12 %(Rs) 6,000
EPF corpus after 20 years (Rs) 3,788,641.16
Amount of cut in salary at 20% 4,500
salary after the pay cut (Rs) 20,500
EPF after pay cut at 12 % (Rs) 4,920
EPF corpus after 20 years after the pay cut (Rs) 3,106,685.75
Difference in corpus (Rs) 6,81,955.41
Illustration purpose only
(Source: Personalfn Research)

Gratutity reduced

Gratuity is another benefit that helps build one's retirement corpus. It is a benefit paid as 'Gratitude' by the employer to his employee for his/her services and commitment towards the company if he/she has worked for 5 years or more.

Usually, the employee receives this payment at the time of retirement, but under special circumstances like employee resignation or on demise, this can change.

After completing five years of service, the organization has to pay an amount equaling 15 days of the last drawn salary for each year of service.

Suppose the person's last drawn salary is 30000, the person receives a gratuity of Rs 4,84,615 when he retires at age 60 would after completing 28 years in an organisation. When the person receives an 18 % drop in his salary, his gratuity reduces to Rs 3,97,385.

It is calculated as: last drawn salary divided by 26 (number of working days in a month) x 15 days x number of years of service.

Table 2: Decrease in gratuity.
Last drawn salary (Rs) 30,000
Total number of years a person worked in the company (yrs) 28
Gratutity before pay cut (Rs) 4,84,615
Amount of cut in salary at 18% (Rs) 5,400
Salary after the pay cut (Rs) 24,600
Gratutity after pay cut (Rs) 3,97,385
Deduction in gratutity (Rs) 87,231
Illustration purpose only
(Source: Personalfn Research)

The salary cut is a serious issue for people who are planning to take early retirement or are on the brink of it. The impact on their PF and gratuity will be more severe as their basic salary will be higher compared to someone who has just begun his career.

How can one increase the retirement kitty?

If you haven't thought of saving for your retirement specifically and your salary has been slashed, have a word with your manager/s to tweak your salary and voluntarily invest in a ppf account as well.

Besides, there are avenues one can consider to invest in so you can still enjoy your retired life. Senior Citizen Saving Scheme (SCSS), Post Office Time Deposits (POTD), Office Monthly Income Scheme (POMIS), National Savings Certificates (NSC), Kisan Vikas Patra (KVP), and Liquid funds or overnight funds and Banking and PSU debt funds.

[Read: Where Can Senior Citizens Invest to Earn Slightly Better Returns than Bank FDs]

Most of the avenues mentioned above are government schemes and the last few are debt funds. Remember debt funds aren't risk-free. Having a diversified retirement kitty will reduce the risk and you will receive a regular income as well, which is a little higher than regular savings and bank FDs that will help you counter inflation.

The idea is to diversify the investments so that you don't face a cash crunch and can meet your day-to-day expenses after you retire. As once you retire, income stops, and expenses continue. The years from the start of retirement till demise are unpredictable, however financially preparing for this time of your lives is imperative for your survival. Your investments/savings will act as a steady source of income during our retirement phase.

In my view, the most suitable approach would be to start planning for your retirement right now! When you do, the time-value of money and the power of compounding will help you accrue the desired retirement corpus.

PS: If you too want to retire blissfully and rich, don't miss out on PersonalFN's Retire Rich service. It is an exclusive service with the sole intent of securing your retirement.

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Warm Regards,
Aditi Murkute
Senior Writer

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