An issue that often confuses expatriates is that of “host-location spendable income.” Since comprehension of this concept is critical to understanding the nature of an expatriate pay package, the following discussion will illustrate it through practical examples.
Start at the Beginning
To grasp the concept of host-location spend- able income, it is necessary to look at your home-country salary. One can describe the ways in which that salary is spent by using four categories of expenditure: goods and services, housing, taxes, and reserve (savings and investments).
The focus in this article is on goods and services. As your income increases, the percent of salary you spend on goods and services decreases; as family size increases, the percent increases, too. When you go on assignment, it is important to know the cost of goods and services in your home country and what you would have to spend in the host location to buy the equivalent amount of goods and services. This determination is evident through the use of the goods and services index and differential.
The goods and services differential that your employer provides to you on a regular basis represents the difference between your home-country and assignment-location spendable income (the amount you spend on goods and services). This differential amount is calculated by means of a goods and services index — that is, a number that summarizes the relative total cost of the market basket of goods and services in the assignment location when compared with a similar basket in your home country at the same point in time. By definition:
- If prices are the same in both locations, the index is 100.
- If costs are higher in the assignment location, the index will be greater than 100 (positive); if costs are lower in the assignment location, the index will be less than 100 (negative).
Therefore, a goods and services index of 150 means that a market basket costing 100 units in the home country would cost 150 units in the assignment location – or, 50 percent more.
The following formula calculates the accompanying differential that your employer would provide to keep your purchasing power “whole” while abroad:
The equation considers 100 to represent that portion of income already being spent by you at home for goods and services (the home-country spendable income). It also assumes that you need the excess of the cost above 100 for the higher prices of goods and services abroad (the differential). For example, if the index is 130 and your monthly spendable income is USD1,000, the differential would be USD300, calculated as:
Then, add the home-country spendable income of USD1,000 and the differential of USD300 to result in USD1,300. Multiply this amount by the exchange rate in effect at the time (assume Z4:USD1) to result in the host- location spendable income (USD1,300 x 4 = Z5,200) – or, the amount needed to purchase the equivalent amount of goods and services in the host location.
The differential is not intended to be the sole amount spent in the host location on goods and services. Just as part of your base pay is spent on goods and services at home, so are you expected to spend that same amount on assignment.
Percent Change in Exchange Rate vs. Differential
There are times when the decrease in the differential far exceeds the percent change in the exchange rate. Assume the exchange rate changes from Z50:USD1 to Z60:USD1 and results in a 20 percent drop in the value of the Z. Assuming the index was 150, the new index becomes 125. If home-country spendable income is USD1,000, you would see a drop in the differential from USD500 to USD250 – a 50 percent decrease in the differential, compared with a 20 percent devaluation.
However, since the differential is the way to get from the costs of goods and services in the home country (USD1,000) to those in the host location, it is necessary to look at the host-location spendable income:
After the devaluation:
So, despite the drop in the currency value, the host-location spendable income has not decreased. Host-location spendable income does not change as exchange rates change. The differential in home-country currency and foreign currency unit changes.
Understanding the Impact of an Exchange Rate Change
What happens to a differential when there is a change in the exchange rate? If, for example, the rate changes from Z4:USD1 to Z5:USD1, all else being equal, the index would decrease from 130 to 104, and the differential in the above situation would drop from USD300 to USD40. That USD40, however, would allow you to buy the same amount of goods and services as before:
Now consider what happens when a new index is calculated as a result of changes in the price of goods and services. Even though prices in the host location have risen, the index (and differential) may drop because of the exchange rate change. If the revised index goes from 130 to 120, there is a drop in the differential (from USD300 to USD200), but an increase in the host-location spendable income:
Here, a smaller differential, when combined with the home-country spendable income and converted at the new exchange rate, buys more host-location spendable income. This increased amount will keep your purchasing
power comparable to what it would have been in the home country, even after the increase in prices in the host location.
Two key points to remember are these:
- A differential should always be combined with the home-country spendable income. By itself, a differential is simply a way to equate costs in two different countries. If a differential is not combined with the home-country spendable income, you may think you are not expected to spend any of your base pay on goods and services in your host
location.
- Once the differential is added to your
home-country spendable income to become the host-location spendable income, the total amount should be converted into foreign currency. As the foreign currency devalues, each unit of home-country currency buys more foreign currency units; consequently, fewer home-country units are necessary.
There are times when the decrease in the differential far exceeds the percent change in the exchange rate. The example in the sidebar, “Percent Change in Exchange Rate vs. Differential,” explains this situation.
One Step Further:The Concept of Split Pay
An employer that follows the split-pay methodology pays part of your compensation in home-country currency and the remainder in foreign currency. Although the way the split is made varies, the best split is usually to pay the host-location spendable income amount in local currency, plus any amount needed for housing in the host location, and pay the rest in home-country currency.
Particularly in economically volatile situations, this approach neutralizes the effect of
currency fluctuations by limiting the need to transfer funds from home to host for daily purchases of goods and services. It protects the portion of your base salary (spendable income, not total pay) to buy what you need in the host country, which protects your purchasing power and lifestyle.
Splitting pay also ensures a stable number of local currency units for the host-location portion (needed for daily living) and home- country currency units (for reserve and incentives). And finally, you do not have to worry about the hassles and fees of converting currency into local funds, particularly since you do not need this portion overseas. All in all, it represents a fair and reasonable approach to pay delivery.
The Bottom Line: Expatriate Satisfaction
Understanding how your international compensation package works is a key element to satisfaction on your assignment. The host- location spendable income is an essential component of that package.
Heather Thomas, an Associate of Mercer, is based in New York.
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