Recent news headlines such as  'First signs of economic recovery' and 'Shimmers of hope' may be optimistic. However, the economic downturn has already affected and continues to affect people in many ways. Expats in particular are sensitive to these economic changes as they deal with multiple economies and currencies and often receive (elements of) pay in a foreign currency. In these troubled times they have a lot more questions for HR and need extra support in understanding their allowances and how they are changing.

To illustrate the scope of the changes, we can look at Moscow, a major expat location which is currently ranked as the city with the most expensive rental costs in 2009. The Russian ruble has devalued considerably, with the USD-RUB rate having changed by 47 percent in the last year, of which 26 percent has been in the last three months up to April 2009. Moscow also experienced 11 percent inflation over the last year (surveyed expat inflation as opposed to local CPI inflation). As a result of these two factors combined, the Cost of Living (COL) Index for USA to Moscow has dropped by 51 points in one year, and 36 points in the last three months alone. Additionally, the expat rental market has seen a decrease in rents of 30 percent between November 2008 and February 2009.

Not only developing economies have been hit by the downturn; the changes have been felt throughout the world. The British pound and the Australian dollar have devalued considerably. High inflation was measured in Venezuela (30+ percent in 12 months). Rental markets have seen rents go down significantly in the last few months to half a year, in places like Singapore, Hong Kong, New Delhi, Dubai, London and Sydney.

This article deals principally with how HR managers who manage expat pay can respond to fluctuating allowances and minimise the effects on expats. Even though expat allowances always change, these times of economic downturn are extra challenging because of the amplitude and frequency of the fluctuations. With general concerns about job security, impending localisations, and other policy changes, expats are becoming increasingly concerned about their assignments and their compensation.   

The global economic crisis
Simply stated, a process that started in July 2007 with the US subprime mortgage crisis, and continued through the subsequent collapse of the housing bubble and a decline in the capital of many banks, has led to a global credit crunch. This economic crisis has had a strong effect on exchange rates and prices in several ways:

•    Central banks have adjusted their interest rates, influencing rates on loans and deposits.
•    Currency speculation has intensified.
•    Demand for certain currencies has dwindled. For example, China is hardly buying commodities from Australia anymore, which has caused the Australian Dollar to fall.
•    Lower demand for commodities has triggered changes in prices.
•    Import/export prices have fluctuated.
•    Governmental policies have been in flux.

In turn, exchange rates have a strong effect on expat pay. Expats transfer money between their home and host locations, their allowances vary due to exchange rate change and they mentally convert host currency to home currency on a daily basis. Higher prices at home or in the host country also lead to an immediate change in the Cost of Living Allowance  (COLA). Note: A COLA is also called a Goods & Services (G&S) Differential or Commodities & Services (C&S) Differential or Host Country Allowance (HCA) etc.

 
Source: www.oanda.com

The economics of expat pay
There are three primary economic factors affecting the elements of expat pay:

•    Home inflation
•    Host inflation
•    Exchange rate changes

The extent to which these factors influence expat pay depends on the orientation of the compensation system. The three most common orientations are:

•    Home: Home Based or Balance Sheet System
•    Headquarters: HQ Balance Sheet System
•    Host: Host Based or Host Plus System

Under the first two options, the home base salary and fringe benefits are kept the same in the host location (the same base salary for an equivalent position). Possibly a hardship and/or foreign service premium are paid as an incentive. In addition, the so-called 'equalised elements of pay 'are used to keep the expat ' whole 'compared to HQ or home.  These elements include a Cost of Living Allowance (COLA), a Housing & Utilities allowance, tax assistance, dependent education and relocation policies.

Under the Host (Plus) System, relocation policies and dependent education are usually provided. However, all other elements may be offered temporarily (during a transition phase, gradually or as a lump-sum) or not at all.

Exposure to volatility will vary according to the type of compensation system:

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The COLA protects home purchasing power, meaning that the expat is protected against the difference in costs between living in the host location and living in the home location. Any changes in relative prices (at home and host) and/or exchange rates are handled via adjustments to the COLA. This ensures that the expat has sufficient home currency to purchase the appropriate amount of host goods and services in the host currency. Other portions of pay that are not spent at the host location are protected in home currency, such as premiums, savings, and limited goods and services spending at home.

Inflation

One of the main factors influencing COLA changes is relative inflation, that is, host inflation compared to home inflation. This is important, as many expats tend to forget that home inflation also impacts their COLA. Since foreign costs are compared to home costs, any change in the home costs must also be taken into account.

Host inflation can also be a 'hot issue ' for expats when it comes to understanding their COLA and how it fluctuates. Newspaper articles may speak of 20 percent inflation while communications from HR about COLA changes show inflation as 'only ' 10 percent. But these numbers measure two different things.  The inflation mentioned in newspaper articles is the local CPI inflation published by governmental departments, whereas the inflation mentioned in HR communications is surveyed expat inflation. The main difference between the two is that expat inflation is measured by collecting pricing information based on an expat market basket of goods and services that includes ‘expat quality‘ and imported products. The shopping basket of an expat is also geared to generally higher salaries than that of a local national. The weights of the different items in the market basket will also differ for a local national compared to an expat, reflecting either local or expat usage. The retail outlets in which pricing data is gathered are also different for locals as compared to expats. Furthermore, expat inflation is based only on goods and services; housing and education are excluded. CPI inflation, however, will sometimes include housing and/or education. Finally, the time period in which inflation is measured may vary.  

Another common challenge around inflation is that expats focus on price increases for products they buy regularly (like Kellogg’s Cornflakes and alcohol) and forget about other products and services that they purchase less frequently, which may not have increased as much in price or may even have decreased (like domestic help, clothing, or auto insurance).

Exchange rate changes aside, the COLA will increase when prices at host increase more than prices at home. In other words, when there is positive relative inflation.  Negative relative inflation (prices at home increased more than at host) will cause a decline in the COLA.

Currency changes

Currency changes, especially around the COLA, create another set of communication challenges for HR. Frequently asked questions from expats are:

•    I had a COLA six months ago, now it’s almost zero. Where is the incentive in my assignment?
•    The GBP hit an all-time low today vs the EUR. Why aren’t you updating my COLA immediately?
•    My COLA went down 50 percent but the exchange rate change was only five percent; this can’t be right!?

Leaving home and/or host inflation out of the equation, the COLA increases as host currency strengthens (the assignment location becomes more expensive) and decreases as host currency weakens. Alternatively, when home currency weakens, more home currency is needed to purchase host currency to buy the same amount of goods and services. As a result, the COLA increases. When home currency strengthens, less home currency is needed to buy host currency, thus the COLA decreases.

An individual’s exposure to volatility in exchange rates and inflation will depend on the package orientation (as described above), where payments are delivered (at home, at host or a combination) and the frequency of fund transfers. The frequency of package updates, how the exchange rate is selected and whether the employer implements interim exchange rate protection between updates will also play an important role.

A sound exchange rate policy protects the expat

An exchange rate policy is meant to protect the expat as much as possible, but it is impossible to protect the employee completely. Ideally, the chosen exchange rate plan fits well with the company’s expat compensation philosophy, method of compensation, payroll capability and administrative resources. Moreover, the company has to take potential currency restrictions in host locations into account.

There are several decisions to be made. For example, which rate shall be used? A spot rate, a monthly average rate, an internal company rate or a vendor selected rate? And will the company use a discounted rate to compensate for wire transfers or will these be paid for? What about the update cycle of the COLA? Is it annual, semi-annual or quarterly? And will interim exchange rate or volatility checks be conducted?

Once the employer has chosen an exchange rate policy, it is important to stick by it and defend it. Proactive communication with the expat on what rates are selected and how rates will affect pay will avoid nasty surprises later in the assignment. Setting up a regular COLA update schedule is the next step. Furthermore, measures of (interim) exchange rate protection have to be taken. Besides interim rate checks or applying a discounted rate, these could include a guaranteed exchange rate or a system of retroactive adjustments.  

Exchange rate monitoring is most often implemented by companies that have a semi-annual or annual, as opposed to a more frequent, COLA update cycle. If the exchange rate changes by (usually) five percent or more, up or down, an interim COLA update will be done. This can be to the expat’s advantage or disadvantage, of course, with the underlying expectation that the company is not overpaying or underpaying the expat for an extended period.

Instead of monitoring exchange rates throughout the year, the company can also decide to pay retroactive adjustments. Let’s say the COLA gets updated semi-annually in January and July. In July the average rate is computed for January through June. Using this average rate, the ' ideal ' COLA is computed and the actual COLA received for this period is subtracted. If the ideal COLA is greater than the initial COLA, the expat will receive a retroactive adjustment in the form of a lump sum payment. Generally, if the employee’s COLA is greater than the ideal COLA, he/she gets to keep the windfall.

Which solution for what type of expat package?

We can conclude that there are different ways to protect expat pay against currency fluctuations and inflation. Depending on the orientation of an expat compensation package, some solutions will work better than others. In the case of a Home Based package, the expat will be exposed on the host side if paid 100 percent at home or on the home side if paid 100 percent at host. Alternatively, when paid 100 percent at HQ, the expat is exposed both on the host side and when they transfer money back home. Possible solutions are:

•    More frequent COLA updates – quarterly or monthly?
•    Guaranteed exchange rate for funds transfers (based on a percentage of salary or on the actual amount transferred)
•    Retroactive adjustments
•    Split pay

With a Host Based package, the expat will be paid 100 percent in the host country, meaning he/she is exposed on the home side. Again, a guaranteed exchange rate or retroactive adjustments are potential solutions.

When an expat is paid in a single currency, either at home or in the host country, funds are transferred between home and host at a market rate. When an expat is paid in the host location, money still spent in the home location (ongoing home housing costs, children going to college etc.) and savings are affected. When an expat is paid in the home location, money transferred to host for spending on goods and services and possibly housing is affected. With fund transfers, you ‘win some and lose some.’ Over a three-year expat assignment, for example, the gains and losses may even out. However, the expat will call and email HR with questions and demands if the rate is not changing in his/her favour. Even though the COLA protects the assignee’s purchasing power, only that part of pay spent on goods and services needs to be or should be protected. For instance, savings are not protected, since they remain the same in the home location.

To address these problems, some companies implement ‘split pay’, meaning that the employee can draw a portion of his or her compensation in host currency and the remainder in home currency. Since few or no fund transfers are needed, the expat is protected against exchange rate fluctuations. Either the company determines the pay split or the expat is allowed to choose. An ' optimal pay split ' would be to deliver Spendable Income and COLA (= Host Spendable) in host currency,  along with the total amount of Rent plus Utilities. The Residual, including Hardship, would be paid in home currency. (The Residual is salary less hypothetical tax less home Goods & Services less home Housing Norm, if applicable.)

Although split pay is a great solution, implementing it is not always possible because it requires the company to have a dual payroll system. Besides that, it is more difficult to administer and currency restrictions may apply in some countries.

All in all there are various ways to protect the expat from currency changes. Whatever option is chosen, it’s important to be proactive in communicating with the expat to manage their expectations before they go on assignment. In these times of economic downturn, the expat has to be reassured even more than usual that HR is on top of things and will monitor change. Additionally, the expat has to be educated about exchange rate policy (how the rate is determined and when/how it is reviewed) and expat allowances and update schedules, as well as about support for wire transfers or banking fees. In this way, hopefully nasty surprises during an assignment can be avoided and the expat will focus on the job instead of on compensation.

Monique Neijzen is Manager Client Services and Consultant Client Programs Development Associates for International Research, Inc. (AIRINC)

28  May 2009