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Global Compensation Learn the ABCs

July 1, 1995
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Related Topics: Compensation Design and Communication, Global Employment Law, Expatriate Management, Featured Article
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If American businesses are going to thrive in today's global marketplace, costs—and the effective use of overseas assignments—take on increasing importance. While the numbers of expatriates may dwindle as a company manages its operations with local nationals, they're crucial early-on. Compensating expatriates in a cost-effective way that maximizes performance is one key element to accomplishing the business mission.

"Everybody's talking about expansion. You have to have people out there to expand into the globe," says Gary L. Parker, managing director, ECA Windham, LLC, a New York-based firm that collects worldwide compensation information. "It doesn't happen overnight, so if you're a U.S.-headquartered company, you want your nationals to take the corporate message out.

"On the other hand, people are saying they have to reduce the humongous costs, so they want to cut staff. These goals are diametrically opposed. Businesses want to cut back on people just at the time they're trying to expand globally."

Smart companies balance business objectives with the compensation package—base salary, taxes, allowances, CO-LAs, housing and reimbursable expenses.

Compensation policies should support business objectives.
The basics of international compensation for expatriates include: the different methods of calculating payment, remuneration packages and cost-containment alternatives. Expatriates are traditionally a small but very important part of the initial staffing of a global organization. But they're expensive. Global compensation costs somewhere between three and five times the total of one's home salary, allowances and taxes. No wonder organizations are scrutinizing their international assignments. An effective policy takes all of these factors into consideration and fundamentally supports the objectives of the business.

"The most important thing is to know what you're trying to accomplish," says Calvin Reynolds, president of New York-based Industrial Relations Counselors, Inc. (IRC) and a senior counselor at Organization Resources Counselors, Inc. (ORC). (He was previously ORC's senior vice president.) Reynolds says one must determine the kind of mobility important to the organization. You should consider whether you want the expatriates to come home, stay out or move from country to country. Time frames also are important; expats may stay for long or short periods. "Until you figure out what you're trying to accomplish in terms of mobility and staffing, it's impossible to develop a sound international compensation policy," says Reynolds.

In the beginning, it may seem premature to think about staffing strategies. The initial focus is to get a few qualified people to agree to leave, prepare them culturally, pay them and administer the compensation in a way that works for the company. Once an assignee has been selected, Reynolds says companies think, "Now, how do we bribe [him or her] to go and do it?" Companies don't think about it from a career or business perspective. "When somebody first starts out, typically you negotiate a deal that gets them to go. Sometimes it works and sometimes it doesn't," he says. "That usually influences whether or not a company stays in international business."

The wisest step is to consider the business strategy—why you're sending people abroad. "When senior management sees all the costs, they can stop and ask, 'Is this million-dollar price tag on somebody making $100,000 a year going to have payback?'" says Bill R. Sheridan, director of International Compensation Services, National Foreign Trade Council (NFTC). "Are they going to generate a million dollars worth of revenue? Are they bringing some technology or knowledge into the other operating unit that justifies that cost? That's the dilemma, historically."

Assignments vary in length and should correlate to business objectives. They can be: short-term, usually less than one year; average or mid-term, between two and five years (the most common); and long-term or indefinite. Some companies also have business trippers, or extended travel that lasts up to three months. In addition, there are individuals who constitute a cadre of international employees who may never return to domestic headquarters, yet aren't considered a long-term employee in one specific destination, either.

There are numerous reasons companies send expatriates, each of which has implications for the way they're paid. For example, if an expatriate is relocating indefinitely, you might consider a compensation strategy based on host-country salaries. It's crucial to understand not just what the company's goals are and why it's sending expatriates, but, when figuring compensation, remember that employees, too, have personal reasons for wanting to take an international assignment. Among them are the possibility of career advancement, skill development and personal travel interest.

Companies typically send expatriates for the following reasons:

  • To make a technology or skill transfer. This would be an opportunity to either teach or learn from people in the destination, usually for a specified time or project
  • To fill a special managerial skill that's lacking at the destination
  • To form a link with domestic headquarters, as a way to either develop or impart a uniform corporate culture, or to provide a guiding presence for the operation
  • To enable an employee to acquire an international perspective and learn about the company's global scope
  • To give senior management a global opportunity by monitoring such operations.

Use a variety of methods to calculate compensation.
There are several methods companies use for determining compensation: the Balance-sheet or Home-based approach; the Host-based approach; the Better-of-Home-or-Host approach; and the International approach. The most common approach used in the United States is the balance sheet, according to ORC, the New York-based international human resources consulting firm.

In fact, in its 1994 Worldwide Comparison of International Policies and Practices, ORC found that approximately 85% of American firms actually use this method. Many European companies will refer to this as a home-country build-up (the survey found that in the United Kingdom and France, it was used 69% of the time).

The balance sheet starts with a home-country salary (wherever that home base is) and builds upon that foundation. One reason it became so popular is that it facilitates mobility as employees move from headquarters to host-country operations. It also aids repatriation. The underlying philosophy of this approach is that expatriates shouldn't lose or gain in spending power simply because they're transferred to an international location. The balance-sheet approach equalizes purchasing power. The balance sheet starts with the home salary, minus a hypothetical tax (which yields a net income). Then, allowances (or differentials) are added to make up the difference between costs in the host and home country so the employee retains approximately the same standard of living. Finally, to protect the employee's spending power, add the appropriate amount of local tax so the employee won't be paying for it out of pocket. Tax is levied against the allowances and against the payment for taxes.

Though the balance sheet is the most frequently used method, the drawback can be its cost. "While the balance sheet seems straightforward, there are as many [variations] as there are companies using it," says Reynolds. "If you move somebody from the U.S. to a high-cost country such as Japan, or to some low-cost countries in South Asia, from a purchasing power perspective, it shouldn't make any difference if applied properly. However, the way some companies apply the balance sheet may allow windfalls to the employee in taxes and housing allowances, or even in goods and services." There are a variety of ways to control those costs, he explains. The most important is to limit the level of housing an expatriate can rent. "If an expatriate is in Tokyo, it will cost in excess of $150,000 per year to rent a house comparable to one you can get in the States."

Another drawback of the balance sheet is that it may create situations in which there's inequity between expatriates and local nationals, and even among expatriates who come from different countries. Furthermore, "Even though this system is well accepted and easy to explain to expatriates, administration in volatile currency countries can be overwhelming," says Carolyn Gould, senior manager, expatriate compensation consulting, Price Waterhouse LLP. The 1994 Price Waterhouse, 421-company survey of expatriate compensation and tax-balancing policies indicates that companies need one full-time administrator for every 30 expatriates. "Companies may have to update packages on a monthly basis," she says.

Some companies tie compensation to host-country standards.
Another compensation method is the destination-based approach, which calculates remuneration by host-country standards. It ties the expat's compensation to the local organization, and is often used when a company wants the expatriate to be closely associated with the local operation. Typically, companies will also add housing and other allowances to the employee's salary. Although it's easier to administer in many cases, and was designed to save money, individual negotiations can make it very complicated as well as costly.

One of the drawbacks is that currency fluctuations can cause major problems with the host-country approach. When expatriates compare their overseas salary with their home country, for one year they may be happy; another year, unhappy.

Gould says a large number of European companies use the host-country approach because expatriates leaving Europe go to countries where local packages may be greater than a balance-sheet package. To minimize administration, the companies put them on a local package.

The better-of-home-or-host approach is another method beginning to gain popularity. The idea behind this is that no expatriate should have to live at lower than a local level. The Price Waterhouse survey found U.S.-based companies use this approach only 2% of the time, but non-U.S. companies use it 11% of the time. "More companies are struggling to try to make sense of it since they're handling different nationalities. Every nationality comes from a different perspective about what would motivate them to take an assignment," says Gould. For example, an American is very open to the concept of tax equalization, which is generally the result of Americans having a lower home-country tax rate and dealing with the high tax rates overseas. But a British expat isn't as open to tax equalization because in many of the countries, they could be assigned to, taxes are lower than at home. "So every time you deal with a new nationality, you get a new perspective about how they feel about the package," says Gould.

The international approach tries to create an equitable system among all international employees. It's especially useful for highly placed executives who will be moving from location to location. Usually, this approach begins with a common point of reference for senior-level management who receive equivalent pay and benefits regardless of country of origin or destination.

Benefits also will be calculated to reflect the special status of these individuals. According to J. Stewart Black, Hal. B. Gregersen and Mark E. Mendenhall in Global Assignments, published by Jossey-Bass, 1992, although international compensation systems should promote equity, they often don't. "The notion of equity assumes that . . . employees at the same organizational level, performing at virtually the same level of performance, would expect quite similar rewards." The strict balance-sheet approach may not do that and, consequently, may not contribute to a global viewpoint. Since expats in the same location doing similar jobs but coming from different countries will have different pay (because their compensation is calculated on their home pay), inequity is built-in.

In addition to salary, taxes and benefits, expatriates also receive different allowances as part of their overall compensation. Expatriates receive payment to protect their spending capability; it varies depending upon the employee's level in the company, the family size and the destination. For example, foreign-service premiums are financial payments to induce employees to relocate. According to Runzheimer International, the international data collection and consultancy firm headquartered in Rochester, Wisconsin, 54% don't grant such premiums. However, when this type of incentive is paid, it's usually calculated at about 10% to 15% of base pay, according to ORC's 1994 survey. One of the problems with a foreign-service premium is that many expatriates believe it's part of their salary because it's often included in their paychecks.

Another recent study, conducted by the National Foreign Trade Council (NFTC), a New York City-based not-for-profit organization that facilitates information exchange between major U.S. corporations and monitors trade-related legislation, indicates that some companies, particularly in financial services and consumer products, are moving away from the concept of foreign-service premiums toward what's called mobility allowances.

"In truth," says Sheridan, "the assignee might get about the same number of dollars, but the monies are bundled up. Part is given at the beginning and part is given after the assignment's completion. Under the old foreign-service premium approach, the employee receives money each month, and when the person repatriates and that money is taken away, they have sticker shock because they've come to rely on it as a portion of their income."

The mobility allowance is tied to the actual move. "The economic value may be about $10,000 a year, but instead of getting $800 a month ($30,000 for a three-year assignment), the expatriate gets $15,000 at one clip and the other $15,000 at the end. If they quit while on foreign assignment, they don't get it," he says. In some circumstances, the money can also be delivered in a more tax-effective way for the employer. (The Price Waterhouse survey found that 70% provide either a foreign service or mobility premium).

Another type of premium is the hardship allowance. In the past, hardship allowances were paid in addition to the foreign-service premiums. More and more, they're being phased out except in cases where expatriates face extreme difficulty and poor living conditions. In the Runzheimer survey, about 73% of companies still pay hardship premiums and identify which countries qualify for hardship allowances based on data provided by either State Department recommendations or outside consultants. To figure out the appropriate compensation, many organizations gauge competitive practices by using data providers or networking with other companies in the same industry.

One of the most frequently asked questions is about cost of living. Cost-of-living allowances (COLA) help expats maintain the same standard of living they had in the home country. Companies collect COLA information by tracking typical consumer spending patterns in a "market basket of goods and services" and by calculating prices in the destination countries. The difference between prices in the destination country and those in the expat's home country are the differential, and if the destination country's prices are higher, the company awards the expat a COLA. If, however, the differential is negative ( meaning host-country costs are lower), 83% of companies ignore it. Forty-five percent of companies review their allowances semi-annually; 20% review them each pay period.

Since the information is such a fundamental part of the compensation package, it must be up to date and accurate. One of the most important characteristics of a data provider is the frequency with which it reviews and adjusts its calculations, thus protecting against a shrinking of the COLA due to frequently overlooked inflation and exchange-rate fluctuations. Imagine what happened to compensation standards in Mexico after January's peso devaluation. And with high annual inflation, the potential effects on discretionary spending are huge.

Data providers vary, as do the allowances they advise, and consequently it's important to find out who collects their data, how frequently it's updated, if they have information for all the countries you need, and how they calculate their market basket. This last factor is extremely important, and is changing. Because of cost-containment concerns, many companies are creating "efficient shopper indexes," which calculate COLAs with the assumption that the expatriate will learn the most efficient way to save money.

Housing and taxes constitute the greatest expenditures.
A housing allowance lets expatriates maintain a lifestyle similar to the one they had at home. Although it's clearly impossible to recreate a U.S. experience abroad, the allowance tries to grant comparable living accommodations. This part of the compensation package, along with taxes, constitutes the greatest expenditure. It's based on the expatriate's status as well as the size of the family. According to Runzheimer, for example, a typical dwelling for a family of four in Hong Kong (for an employee making $75,000 U.S. dollars and one making $150,000) may range from $145,000 to $224,000 annually; a dwelling in Geneva may range from $55,000 to $68,000.

Data services, like those mentioned above, select specific neighborhoods international assignees tend to live in and survey different types of housing. The housing tables they create detail the type of accommodation and the price range. Again, the information is only as good as its timeliness. For instance, with the rapid housing inflation costs in Hong Kong, within a few months apartments can go from being affordable to being beyond reach. In fact, there are tales of the throngs of expats in Hong Kong who created a virtual exodus from one neighborhood to another because they had to find less expensive housing when their leases expired. Housing inflation had risen sharply during their residence.

Companies differ in policies regarding employee contributions to housing. Almost 60% of companies use outside-party data sources to help fix appropriate contributions. Those who do charge a housing contribution determine it by finding the differential between the United States and the host country, then decide the allowance's size. Whether the lease is kept in the company's or the expat's name is determined by location and by the tax treatment.

Taxes are a major company expense. And they're complex, making tax professionals crucial in this area. Because taxes take such a bite, thoughtful tax planning will likely save the company money. The United States taxes all its citizens, whether they make the money in or live in the United States or abroad. This practice sets up a situation for double taxation—in the host country as well as the home country. Plus, not only the base salary is taxable; the allowances and many benefits can be taxed as well. When you consider that tax rates in Japan, for example, exceed 60%, you can see how expensive it becomes.

The two most popular ways to address taxation are through tax protection or tax equalization. Tax protection means the employees pay no more tax than they would if they lived in the United States. The company would reimburse employees for any taxes out of pocket, but would allow them to keep the difference if the taxes were lower. This would actually create a windfall for the employee. Tax equalization means that the expatriate pays no more and no less than if he or she stayed home. In this case, employees pay a hypothetical tax on wages, just as they would if they were home. "Companies moved from using tax protection to tax equalization after realizing that the tax benefit became an invisible part of their compensation package," says Marcia Marsh, partner in international assignment services practice for Price Waterhouse. "Tax equalization neutralizes taxes and enhances mobility. Also, as companies became more cost conscious, they realized that [tax protection] provided an unintended compensation benefit. When you neutralize taxes, it's a more palatable way to reduce the overall cost of the package."

Adds Gould: "A second reason companies have switched to tax equalization is tax compliance. Under tax equalization, the actual tax payments aren't important to the expat since they're funded by the company. As a result, there's no incentive to under- or over-report compensation. Under tax protection, however, any tax savings accrue to the employee, and as a result, they'll spend a much larger portion of their time trying to reduce their actual tax bill."

The ORC survey reports that 92% of all U.S. organizations use tax equalization. In the vast majority of cases companies administer their employees' tax responsibilities. In other words, firms make sure their employees comply with international taxation requirements.

Educational expenses must also be considered. Quality education is many expatriate parents' first worry. Companies almost always reimburse employees for educational expenses for children in elementary and secondary school—typically covering tuition, books and miscellaneous fees for private, international schools. When students need boarding school, firms provide for such allowances. Expatriates who have college-age students frequently receive airline tickets so their children may visit.

Companies usually also provide some type of transportation allowance. It ranges from a company car and driver to a lump-sum allowance for transportation. An annual trip home is usually guaranteed, with firms paying for round-trip coach for the entire family.

Other remuneration allowances cover relocation expenses, such as managing property, moving household goods and storing furniture at home, helping to find living arrangements in the destination, cross-cultural counseling, and paying for a familiarization trip before the assignment. The latter often includes help with finding schools for the children. Transportation, furniture and other miscellaneous expenses are often covered by allowances as well.

As far as employee benefits go, typically, employees retain the benefits they had at home. However, like other aspects of the package, careful consideration helps to keep the package sensible. This is often tricky, especially in the areas of retirement, stock options and medical coverage.

Pay attention to cost control in developing policies.
Parker sees a return to centralized policy development. "Ten years ago there was a trend toward decentralizing both policy and administration, giving more to the individual business sectors," he says. Problem was, Parker adds, everything was strictly bottomline driven, so units could do only what they could afford, which resulted in people within the same company receiving vastly different packages. "Today, we're going back to being more strategically centralized, especially for policy development. This has brought back a little bit more management control and efficiency, and when the process is centralized, it can be benchmarked to the industry."

In addition to a more consistent application and fairer treatment of employees, a centralized policy can help contain costs. "Instead of a company buying data from three different providers who give varying data, you coordinate with one and create a more efficient framework," says Parker.

Centralizing policies further helps cut costs because international HR practitioners can look at their compensation packages in a companywide context. "Instead of looking at each package's individual components, look at the whole package in light of tax concessions and the high cost of living in certain countries," he says.

Another trend is that global HR conducts more administration and general relocation management. But, in order to do this, HR professionals have to understand the complex world of international compensation. "If you're the international HR manager, and you're responsible for all divisions and subsidiaries and locations outside the U.S., it's impossible to know everything. You have to know about tax, how it's different around the world, and the special tax reliefs that have been provided for expats in some countries," says Parker.

Besides taxes, global HR managers also need to administer housing costs. In the past, says Gould, if someone was renting at a loss, the company would reimburse them for that loss. Now, many of the companies she works with use cash-flow analysis to see if there's an overall loss. The other issue is the housing differential. "Companies now give their expatriates a budget figure, but pay the actual amount," says Gould. In the past, the employee realized the savings.

Indeed, as the focus shifts from begging employees to accept an international assignment to seeing it as a business, career and personal opportunity, more organizations will seek ways to both expand and compensate their international assignees equitably. Balancing all the elements is no easy task. But the effort will ensure that the company achieves its business objectives abroad.

Personnel Journal, July 1995, Vol. 74, No. 7, pp. 70-76.

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