When establishing an expatriate’s compensation package, companies most frequently seek to preserve the assignee’s financial situation at the host location. A popular approach to expatriate compensation is the home-based balance sheet methodology, the intent of which is to match the employee’s home-country purchasing power at the host location. The home-based balance sheet approach assumes that a portion of home-country income is spent on each of the following expenditure categories: taxes, housing, and goods and services. A further assumption is that for each of these expenditure categories, the costs in the host country are going to be different than what they would have been at home:
- Employers typically handle taxes through whatever tax provisions and policies they may have in place: tax equalization, tax protection, or laissez faire. The objective is usually to ensure that the assignee’s tax obligation is no more and no less than if the assignment had not taken place.
- A host-country housing allowance in tandem with a home housing norm deduction is a common method for addressing the housing expenditure piece.
- The home-country spendable income represents the portion of home-country income that an assignee uses on day-to- day purchases. If the cost of goods and services is higher in the host location, companies usually include a cost-of-living adjustment or allowance (COLA) as part of the assignment compensation package.
- Home and host housing
- Miscellaneous Relocation Allowance
The purpose of this discussion is to focus more closely on the third component: the COLA.
Foundational Concepts
Before reflecting more closely on the concept of COLA, its purpose, and its effects on the expatriate’s compensation package while on assignment, it is important to consider the following concepts.
- Home-country spendable income is the portion of the assignee’s home-country income that covers everyday needs, such as food, clothing, transportation, recreation, and so on.
- The cost-of-living index represents a ratio developed by comparing the cost of a fixed market basket of goods and services in the home country against the cost of a similar market basket of goods
Vadim Kostovski and services at the host location. One can also view the cost-of-living index as a numerical representation of the host-location spend- able income
- Host-location spendable income is the amount needed by the assignee at the host location to purchase a quantity and quality of goods and services that are similar to what the assignee could afford at home with a given salary level. The host-location spend- able income is comprised of two parts: the amount the assignee would have spent on goods and services at home (home-country spendable income) plus a COLA (if applicable). If one considers the index as a numerical representation of the host-location spendable income, an index of 135.5376, for example, means that for every USD 100 spent on goods and services at home, the host-country equivalent is USD 135.54.
COLA represents the difference between the cost of goods and services purchased at home and the cost of purchasing similar items in the host location. Chart 1, “How Variables Affect COLA,” on page 7, depicts the impact on the COLA by variables such as the exchange rate, price changes, and changes to the home- country spendable income.
- The home-country spendable income, between January 1 and October 1, changed from USD 100,000 to USD 100,600. Home-country spendable income amounts experience movement due to changes in family size, salary, and/or home-country expenditure patterns (as defined by the home-country government).
The index changed by 4.4% in that same period, as a result of the following:
- Exchange rate: The value of the home-country currency increased by 7.4%. Effectively, it means that an assignee needs less home-country currency to purchase the host-location currency equivalent of the host-location spendable income. The home-country spendable income amount remained effectively unchanged.
- Pricing: The host-location spendable income increased by 3.3%, of which 0.6% is the result of changes in the home-country spendable income and 2.7% is the result of costs increasing in the United Kingdom faster than in the United States.
The variances due to pricing and exchange rate are relatively minor in comparison to the effect the changes have on the actual COLA amounts. Recall that the COLA differential is an amount intended as a supplement to the home-country spendable income, converted to host currency.
January 1
Home-country spendable income = USD 100,000 x GBP 0.6356 = GBP 63,560
The remaining COLA in GBP needed to match the host-location spendable income amount =
October 1
Home-country spendable income = USD 100,600 x 0.6829 = GBP 68,700
The remaining COLA in GBP needed to match the host-location spendable income amount =
As can be seen from this example, while the COLA differential changed by an apparently significant amount (from USD 35,538 to USD 29,739, a 16.3% decrease), the actual amount available to the assignees for purchases in the host country remained relatively unchanged in host-currency terms.
In Summary
The conclusion that can be drawn from the above analysis is that employers should communicate adjustments to assignee compensation packages that occur as a result of quarterly, semi-annual, or annual changes to the COLA in terms of the host-location spend- able income. It is equally important to stress to assignees that the host-location spendable amount is composed of two parts:
- The first part is the host-location currency equivalent of the home-country spendable income amount supplemented by COLA.
- COLA covers the portion of the host-location spendable in- come not covered by the home-country spendable income.
Variables such as the exchange rate and/or changes to domestic and host-country expenditure patterns will influence the amount of the COLA supplement that is necessary. As COLA is the variable portion of the composite host-location spendable income amount, variances due to exchange rate, pricing, and changes in expenditure patterns will be reflected fully in changes to the absolute COLA value.
Vadim Kostovski, an Associate in Mercer’s mobility practice, is based in New York.