Mobility Basics: negative cost of living indices
Opinions are divided on whether or not to apply negative cost of living indices. This post weighs up the pros and cons of doing so.
A cost of living index gives the percentage difference in living costs between a home and host country. Many multinational companies use these indices when calculating salary packages for their international assignees. When this index is applied to the spendable portion of home country income, the resulting cost of living adjustment (COLA) is designed to maintain assignees’ purchasing power so that they are no better or worse off when living abroad. As the cost of living can be either higher or lower in the host location, this amount can be either positive or negative.
Whether or not to apply negative indices (i.e. indices of less than 100) is a key consideration for companies when writing or reviewing their international mobility policies. To decide whether to apply a negative index, both the pros and cons of doing so need to be considered.
Pros of not applying a negative index
Ease of explanation
Although the COLA should be considered as a cost of living adjustment, meaning it can be either positive or negative, many refer to a cost of living allowance – which by nature is positive. This association means it can be difficult to explain a negative adjustment to assignees, who might be expecting an additional amount to uplift their home spendable. Explaining any type of salary deduction can be challenging, even if, as in this case, it means the employee will be no worse off.
Providing an incentive
Some would argue that a negative COLA is demotivating and more likely to make a potential assignee refuse the position on offer. Some companies decide not to apply a negative index, thereby increasing an assignee’s standard of living, to motivate staff to go on assignment. However, the COLA is not meant to be an incentive; its purpose is to adjust the assignee’s salary for the difference in prices.
Cons of not applying a negative index
Let’s look at a hypothetical example where an index of 80.2 has not been applied. At first the assignee benefits from a 19.8 percent increase in their spendable income and therefore enjoys a higher standard of living while abroad. Host country inflation then rises significantly and by the time of the next salary review the index has risen to 94.5. Despite this notable increase the index remains negative and therefore no additional amount is paid by the company to adjust for the rise in cost of living.
As the assignee’s spending increases in line with rising inflation, they will likely question why their salary package is not also increasing to reflect the reality they are experiencing. This is where transparency is key. If companies choose not to apply negative indices they should make their employees aware, prior to the assignment, that they will be getting a windfall which may reduce depending on price changes and exchange rate movements. This transparency may result in less assignee kickback if such a situation arises.
Not applying a negative index means that certain locations will be more appealing than others and therefore creates “good” and “bad” postings. In locations where a positive cost of living index is applied the expatriate will be no worse off on assignment than at home. However, in locations where a negative index should be applied but isn’t, expatriates benefit from an increased standard of living compared to at home. This precludes equity amongst employees.
Not applying a negative index may also inhibit repatriation as the employee may be reluctant to return to a lower standard of living back in the home country. This is where companies run the risk of losing talent to competitors, as they are unable to offer an equally attractive package on local terms.
Assignees are unlikely to consider the impact of tax on the windfall they receive. Companies who apply a tax equalisation or tax protection policy may have to pay taxes due on the windfall, which can add up to a substantial amount if there are a large number of assignees receiving one. Given the increasing pressure for companies to contain costs, this tax implication may be an area worth reviewing.
What do companies do in practice?
31 percent of companies apply negative indices; however, a small proportion of them restrict any deduction from home country spendable. For example, a negative adjustment is only made if the cost of living index is below a specified figure (most commonly cited are indices below either 80 or 90). Overall practice has not changed significantly in the past five or six years.
It is interesting to note that larger international organisations who send assignees to and from many countries are significantly more likely to apply negative indices. For example, 59 percent of companies who employ over 500 expatriates, originating from more than 21 countries, apply negative indices. Many of these employers recognise that ignoring negative indices would significantly undermine both the equitability and cost-effectiveness of their approach.
Many employers recognise the disadvantages in not applying negative indices but find it difficult to explain the negative deduction in the salary calculation. This may be due to the prevalence of quoting a separate cost of living adjustment in the calculations, as 75 percent of companies do. An alternative is to combine the COLA with the home country spendable income to quote a host country spendable amount, which is the total net cash amount required in the host country to cover day to day living costs.
Only 22 percent of companies who quote the COLA separately make negative adjustments for cost of living (where applicable). In contrast, 50 percent of those who quote a host country spendable income apply negative indices.
Opinions on whether to apply a negative index or not remain divided. Benchmarking information shows that the majority of companies do not apply negative indices, but both the advantages and disadvantages need to be considered before a company can make an informed and defendable decision.