The aim of the home country “balance sheet” approach is to keep the employee’s purchasing and savings power whole. The way this is achieved will vary depending on the pay delivery model that a company may have and its impact on the two components of the home country net income – the savings and the spendable income.
 
The savings capacity should be protected against exchange rate fluctuations while the spendable income has to be protected against both price and exchange rate fluctuations. The latter is normally achieved by the cost of living allowance (COLA). 

The impact of currency changes and price increases will not be the same if the employee is paid in host or home country currency. For this reason Mercer has identified three main scenarios around pay delivery to highlight the consequences:

• Pay delivery in home country currency
• Pay delivery in host country currency
• Split payment

1. Pay delivery in home country currency    

In this scenario, the savings and spendable income and the cost of living allowance are paid in home country currency. The employee will convert a part into local currency on a regular basis to meet living expenses in the host country. As a result, the employee may see variations in local currency when converting the same amount monthly. There may be gains and loses compared to the original estimates. There is no impact on the savings portion because only what is spent locally is affected by the exchange rate. The savings remains in home country currency. 

We recommend that the inflation and market exchanges rates are monitored on a regular basis and that: 

• An exchange rate fluctuation over a 10% threshold triggers a recalculation of the COLA
• An annualized inflation in the host country over 10% triggers a recalculation of the COLA 

2. Pay delivery in host country currency  

In this scenario the savings and spendable income and the cost of living allowance are converted into a fixed amount to be paid in host currency. The exchange rate used to make this conversion is likely to be the rate used to calculate the “cost of living allowance.” In this case, an exchange rate fluctuation will impact directly the conversion of the savings portion back to home currency but not the spendable income. The cost of living allowance may be reviewed for host country inflation.
We recommend that the inflation and the market exchange rates are monitored on a regular basis and that:

• An exchange rate fluctuation over a 10% threshold triggers a recalculation of the  host country amount (including savings, spendable income and the cost of living allowance)
• A host country inflation rate of over 10% triggers a recalculation of the COLA 

3. Employee paid partly in home country currency and partly in host country currency (split pay)

The savings and incentives are paid in home country currency and the spendable income and COLA in the host country currency as determined through the balance sheet calculation results. The savings part is protected against any currency fluctuation because it is paid in the home country. The spendable income and the cost of living allowance are on the other hand paid in local currency. 
In this situation we recommend

• An annual review to reflect changes to salary, personal situation and price and exchange rate differences from year to year
• That a host country inflation rate of over 10% triggers a recalculation of the COLA

Annual vs. more frequent salary / COLA adjustments 

Expatriate compensation adjustment should occur only after a change to the home base salary, a change in family situation or important exchange rate and price fluctuations. Updating systematically the COLA at mid year may result in unnecessary communication issues. 

Indeed, the cost of living index takes into account the difference between price movements in both the home and the host locations. So imagine a situation where 6 months after the original calculation a new index is produced. Let’s assume the prices increase more in the home city than in the host city and the exchange rate remains the same. In this case the Cost of Living index will reflect that the base city has become more expensive than the host city and will fall.  

Periodic checks, such as a mid year a review should only aim to correct for an important exchange rate fluctuation or a large price increase in the host country. Apart from these exceptional situations, the Cost of Living allowance should only be recalculated together with the annual home country base salary review.

In doing so, a decrease of the COL index because home prices have increased more than the host prices will not necessarily mean that the expatriate will have less spendable income and cost of living allowance in the host country. Indeed the home country base salary will most likely reflect the increase for the inflation in the home country. This will trigger a higher net income, higher spendable  income, which even multiplied by a lower cost of living index, will result in a higher package. 

These are the main reasons why we recommend setting the cost of living allowance once per year but monitor exchange rate and price movements.