Paying Expatriates: Understanding Split Pay It seems no matter what you do, people complain. A US expat in Paris paid in US dollars complains bitterly when the US dollar weakens. He demands an exchange loss allowance to offset this unfair loss of purchasing power. The same expat keeps quiet while happily cashing in his dollars into euros when the dollar strengthens. When this happens, local management complains loudly that the expat is receiving an unwarranted windfall. Paying in euros is no better: it simply reverses the complaints. Currency fluctuations and exchange rates have a tremendous impact on the amount that an expatriate receives in compensation. Plus, it greatly affects the amount of the cost-of-living allowance that companies pay their expatriates. For these reasons, determining the currency in which to pay the expatriate’s salary is always a delicate exercise. Introducing Split Pay Splitting an expat’s pay between the host and home country currencies can help solve this problem. The amount paid in the host-country currency is meant for day-to-day living expenses while the amount paid in the home-country currency is intended for savings and less frequent purchases or purchases made outside the host country (e.g., furniture, jewelry, vacations). According to Mercer’s most recent International Assignment Survey, 27% of the companies surveyed split the salary payment between home- and host-country currencies while 31% pay in home currency and 23% in host currency. European companies are more likely to split pay than their US counterparts. Interestingly, a large proportion of US firms (54%) pay the entire salary in the home country currency. The core principle of the most common expatriate compensation approach – the balance sheet calculation is: “No gain, no loss”. A fundamental principle of expatriate compensation is that an expat should neither gain nor lose from differentials in living cost or fluctuations in exchange rates. To accomplish this balancing act, expatriate compensation packages are normally split into two parts: Spendable income. This first part is for day-to-day living expenses in the host country. This portion of pay is usually referred to as “spendable income” or “goods & services”. Non-spendable income. The remaining part of the salary is for savings and other expenses, such as furniture, education, holidays, and any housing obligations (e.g., mortgage) in the home country. It can also include the mobility premium and hardship allowance paid by the company. This remaining amount, referred to as “non-spendable income,” would mainly be spent or kept in the home country. A cost-of-living index is usually applied only on the spendable income portion of pay. The logic is that the expat only needs to be protected against cost of living differentials and exchange rate fluctuations on the proportion of pay that is spent in the host country. By applying the cost-of-living index to spendable income, this part of the salary is protected against currency fluctuation and high inflation. Some companies apply the cost of living index on the full net after-tax compensation received by the expatriate. But does it make sense? Savings need not be adjusted for cost of living since savings ultimately will be spent at home after the expat returns from the assignment. Infrequent purchases of “assets” such as furniture, jewelry, vacations, or housing are not normally purchased in the host country either. Thus, there is no reason to adjust this part of the salary for cost-of-living. What employees are looking for is stability. Psychology is the key here: your expatriates will not feel comfortable with your policy if they have the impression that their package can be adversely affected by currency fluctuations and inflation. “No gain/no loss” should be the core principle of a cost-of-living allowance policy when implement a balance sheet approach. Assessing the Different Payment Approaches Let’s assess the different approaches to currency when it comes to paying the salary: Optional approaches to pay delivery Currency Risk? Host currency approach Spendable income Host No risk if protected by Cost-of-living allowance Non-spendable income Host At risk if subsequently converted into the home currency Home currency approach Spendable income Home Limited risk if converted abroad Non-spendable income Home No risk if spent at home; limited risk if spent abroad Split pay Spendable income Host No risk if protected by Cost-of-living allowance Non-spendable income Home No risk if spent at home; limited risk if spent abroad Host currency approach The first option is to pay the entire salary in the host currency. The spendable income portion of the salary is protected by the cost-of-living adjustment, but the remaining portion is exposed to currency fluctuations that might result in loss and gains for the expatriate. There is also something flawed in the logic of this approach: by definition, a large part of the non-spendable income amount (savings) are used in the home country and it does not really make sense to provide this part of the salary entirely in the host currency. Home Currency Approach The second approach is to pay the entire remuneration in the home currency. This approach, favored by many American companies, has some advantages. The non-spendable income paid in the home currency and spent in the home country is protected. The home currency approach provides stability, provided that the home currency stays strong. Nevertheless, there still is a risk with the home currency approach. The expatriate must convert the spendable income into the host currency to pay for daily living expenses. The timing of the exchange could lead to a loss or gain for the expatriate. The loss or gain is especially pronounced when currency volatility is high. Split-pay Approach The third approach, the split pay approach, appears to be the most logical option. Spendable income (which is spent in the host country) is paid in the host currency. The non-spendable income (which is meant to be spent at home) is paid in the home currency. A Potential Solution: A Flexible Split-pay Approach In an ideal world, the company would set a percentage of spendable income that matches exactly the needs of the expatriate. This means the spendable income would exactly reflect what the employee needs in the host location. In reality, while we can identify consumption patterns, we cannot exactly match the spending behavior of each individual expatriate. A better option is to allow the employee the flexibility to decide the percentage of the salary that will be paid in the host currency. For example, a company that sets spendable income at 50% of total after-tax income might give expatriates the option to have between 20% and 70% of the salary paid in the host currency. Let’s assume an American expatriate decides that he wants to receive 70% of his salary in the host currency. The 30% paid in the home currency and used at home does not create any problem. The cost-of-living index is applied on the 50% of the salary paid in host currency. The spendable income is thus protected from fluctuations by the index. What about the remaining 20% paid in the host currency but not covered by the cost-of-living adjustment? The employee can potentially win or lose on this amount due to exchange rate fluctuations. A possible approach would be to guarantee this 20% of the salary against fluctuations. The company would cover any losses but also keep any gains, if the currency fluctuates more than 10%. Exceptions to the Rule In countries with high inflation and/or weak currencies, such as in Africa, Latin America, and Eastern Europe, companies should pay in the home country currency, or in a third “hard” currency. This is very close to the home currency approach. When setting your payment policy, you also have to take into account country laws and currency transfer restrictions. As with many expatriation issues, there is no perfect solution that will fit all situations. However, a clearly defined policy will reassure your employees and make your job easier. Find out more about cost-of-living issues at https://mobilityexchange.mercer.com/cost-of-living.