What is the best way to address inflation and economic volatility for globally mobile talent?
One-way transfers and other host-based compensation assignments have grown in popularity over the past several years. These approaches make sense if the employee’s career is moving to another country, pay equity with local peers is desired, or the host-based compensation is comparable to that at home. These host-based packages are also often appealing to the business because they tend to be less costly due to the lack of tax equalization or the absence of expatriate allowances.
While one-way transfers and host-based approaches serve an important purpose in mobility, they do have drawbacks. Inherently, they don’t offer any exchange rate protection or mechanism for inflation adjustments. While we had been living in a period of relative economic calm, host-based schemes did not come under significant pressure. But, now that economic volatility has returned, expatriates have legitimate concerns about host-based compensation -- especially in countries which have seen large currency drops or high inflation (see more here "Weakness Hits Salaries for UK Employees - Bloomberg". So, what can mobility do?
This is where the home-based balance sheet comes in to save the day. There is a reason this approach used to be the standard for all expatriates: When economic volatility strikes, the balance sheet automatically rebalances.
Unfortunately, the balance sheet has gotten a bit of a bad reputation for being expensive and administratively cumbersome. While this is true, sometimes the investment is worth it.
The balance sheet does a wonderful thing: It recognizes that the employee lives in a dual currency world. Expatriates have financial obligations at home and at host, and the rebalancing that occurs during the assignment helps protect both of these obligations.
The balance sheet allows the employee to retain the home country rate of compensation in home currency, protecting it from exposure to exchange rate fluctuations in the assignment location. The pay is anchored to home currency throughout the assignment, and the employee can continue to meet important financial obligations at home such as funding retirement, saving, paying student loan debt, saving for children’s education, or retaining a home residence. It also makes it easy to repatriate the employee at the end of an assignment as they have never left the home pay scheme.
In addition, it facilitates the deduction of a home hypothetical tax in home currency which allows the employee to continue to pay income taxes at a stay-at-home rate. The company pays host taxes through tax equalization, thus eliminating the employee’s exposure to host currency obligations (as well as potentially higher host country tax obligations).
A significant portion of the expatriate’s pay is also needed in host currency. The expatriate lives in the host country and buys goods and services (G&S) in host country currency. The part of salary spent on G&S is the highest of all expenses -- typically around 40-50%. This leaves a significant portion of the employee’s salary exposed to exchange rate risk, inflation, and potentially higher costs in the host location: This is where the COLA comes in really handy.
The COLA is the difference in the cost of G&S between the host and home countries. Right off the bat, the COLA protects the employee against excess costs if the host location is more expensive, but it also allows for this COLA to be rebalanced regularly during the assignment to reflect any changes in exchange rate and inflation.
Because the COLA is the difference in host and home costs, both inflation and exchange rate change can be considered when it is recalculated. This is where strong protection for the employee comes into play. When host location inflation is relatively high, the COLA will increase to reflect increased host prices relative to home prices. And when the home currency weakens, the COLA will increase to ensure the employee has more funds to buy host currency.
The COLA can also decrease -- which may seem alarming, but it is a good thing. If the inflation is lower at host or the home currency is strengthening, less support is needed from the company and the COLA decreases to avoid overpayment, thus rebalancing the payment.
In this time of economic volatility, it is important to update the COLA regularly to ensure this rebalancing can keep up with the pace of change. A good way to protect the employee is to update the COLA quarterly and to communicate very clearly about how the COLA offers protection.
The other large expenditure at host is housing. Typically, housing is covered by the company thus eliminating inflation and exchange rate risk to the employee. For those companies paying a cash allowance for housing, it is important to also update this payment for inflation (or exchange rate if not delivered in host currency) over time.
Give Good Advice
Because the balance sheet offers robust inflation and exchange rate change protection, it merits use in any global mobility policy suite. It should not be the only solution, but companies should know when to invest in it and help the business understand why a lower cost host-based scheme may not be the right solution in all cases.
AIRINC offers COLA change reports to help explain the impact of inflation and exchange rate, as well as an online policy decision guide via AIMS to help companies decide when to use a balance sheet or a host-based scheme. Contact us to see if we can help!