Cost of Living Allowance (COLA) is one of the most common allowances provided to assignees. Because it directly affects take-home pay, it often raises questions: Why did my COLA go up? Why did it go down? Why is it different from last year?
The Two Drivers of COLA
Cost of Living Allowance (COLA) and the COLA index are not static. They change over time, and those changes are driven by only two factors: exchange rate fluctuations and relative inflation.
What Is Relative Inflation?
Relative inflation is the ratio between the host country’s inflation and the home country’s inflation, in other words, host inflation divided by home inflation.
- For example, if home inflation is 2% and host inflation is 5%, the relative inflation works out to 1.05 / 1.02 = 1.0294, or 2.94%.
- On the other hand, if the situation is reversed, say home inflation is 5% and host inflation is 2%, the calculation becomes 1.02 / 1.05 = 0.9714, or -2.86%. In that case, relative inflation turns negative.
Why Home Inflation Matters
Among the three aspects at play (exchange rates, home inflation, and host inflation), home inflation is often the most challenging. When it exceeds host inflation, it generates negative relative inflation. That, in turn, reduces the COLA index, something that can be difficult to explain to expatriates. After all, they may be experiencing rising prices in their host location, yet see their COLA adjustment go down.
The “Out of Sight, Out of Mind” Effect
The reason is simple: expats do not directly experience the inflation happening back home. “Out of sight, out of mind” applies here. Prices are rising in their home country, just as they are everywhere else, but from abroad employees don’t feel it. Yet inflation at home still erodes purchasing power. As salaries stay flat while prices increase, what an employee’s income can actually buy shrinks, at least until the next salary review.
COLA’s True Purpose
This is exactly what COLA is designed to address. Its sole purpose is to help employees maintain their home-country purchasing power. If that purchasing power decreases because of inflation, then COLA must decrease as well. Negative effects from home inflation may sometimes be offset by host inflation or by exchange rate changes, but when we isolate home inflation alone, the result is always a lower COLA index.
A Coffee Example
Let’s look at a simple example. Imagine that in the home country, a large coffee costs 100.0. In the host location, the same coffee costs 50% more. COLA is designed to cover that gap, so in this case the employee’s 100.0 home spendable income is topped up with a COLA of 50.0, allowing them to maintain the same purchasing power abroad. If their home spendable is lower, say 90.9, they can only afford a small coffee — but COLA (45.5) ensures they can buy the same small coffee abroad as well.
Now let’s introduce home inflation. Suppose prices in the home country rise by 10% over the year, while host inflation and exchange rates remain unchanged. That same coffee at home now costs more, and the employee’s 100.0 spendable income no longer stretches to a large coffee. They can only afford the smaller one. In the host country, prices haven’t changed, but compared to the new home situation, the small coffee now costs 36.4% more. COLA adjusts accordingly: instead of 50.0, it is now 36.4. The COLA index has therefore decreased from 150.0 to 136.4, entirely due to home inflation.
This drop can be confusing, even frustrating, for employees abroad. From their perspective, they haven’t seen home inflation firsthand, so they struggle to understand why their COLA is going down while they still face rising costs locally. But if the purpose of COLA is to preserve home purchasing power, and that is its only purpose, then it must decrease when home purchasing power erodes.
Bringing It All Together
Understanding how home inflation affects COLA can be tricky, especially for employees who only see the rising costs in their host location. Visuals and clear examples are essential in explaining this mechanism. They help show employees how COLA works, why it changes, and how their purchasing power is being protected. A more detailed analysis of these changes can be found in our COLA change reports.
If you or your assignees have questions about how COLA works, or need help explaining changes to your assignees, we’re here to support you. Please check out our resources here or contact us.
