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HRs Options for Dealing with Cost-of-Living Issues

April 23, 2002

Has this ever happened to you? Management has offered a job to an executive at your corporate headquarters. The executive is interested, but feels that housing is expensive in the new community. He asks for a salary significantly above the range for the position. The salary he wants is out of the question. Management calls you to help them close the deal. "What can we do about the cost-of-living difference?" they ask.

Is there an effective way to deal with cost-of-living differences without destroying equity in your compensation plan? Cost-of-living difference is the most common barrier to a successful relocation. And sometimes the perception of a cost difference is just as important as an actual, measurable variance in living costs.

There are commonly used policies that can help you deal with the measurable differences between the employee’s hometown and the employee’s destination. The first step is to have a cost-of-living comparison done based on the employee’s income, family size, homeowner status, and origin and destination cities. There are several providers that offer this service.

However, there are some behavioral issues that will affect the perception of the financial assistance offered. These can’t be overlooked.

Let’s address the financial/relocation policy provisions first:

Moderate cost-of-living difference
Let's assume that our employee is moving from Dallas to Denver. His salary is $80,000, he is a homeowner, and he is married with two children. The comparison shows that Denver will be $8,258, or about 10 percent, more expensive. Housing makes up $8,090 of the difference.

At this level of difference, most companies would pay an allowance declining over three years. The first year’s allowance would be $8,258. The second year’s amount is two-thirds of that, or $5,505. In the third year, the allowance is one-third, or $2,753. An alternative would be to pay the entire allowance in one lump sum at the start of the move.

If your employee resigns or is transferred again, the allowance ends. It doesn’t become a permanent part of the compensation package.

Significant cost-of-living difference
In our second scenario, our employee is moving to Chicago instead of Denver. Using the same parameters, the cost-of-living difference is $23,812 -- a 29.8 percent increase! Housing costs make up $21,174 of the difference.

In Dallas, the statistical home value for our employee is $190,000. In Chicago, the comparable home value is $455,000.

If we pay an allowance over three years, our employee gets $23,812 the first year, $15,873 the second year, and $7,937 the third year, for a total of $47,622.

A more effective use of the allowance would be to fund a mortgage subsidy (or buy-down) program for three to five years. The mortgage subsidy helps transferees qualify for a higher loan amount by reducing the interest rate.

With an $80,000 income, our employee may qualify for a $194,000 loan with a mortgage at a 7 percent interest rate. If we provide a four-year mortgage-subsidy program, our employee qualifies for a $306,000 mortgage.

The mortgage qualification for the employee is based on an initial 3 percent mortgage rate. The employer will send a payment directly to the lender to make up for the difference in payments between 7 percent and 3 percent, or $8,948 for the first year. In the second and each subsequent year, the subsidy payment decreases and the employee’s share of the payment increases by the same amount. The total of payments for four years is $22,980.

Mortgage-subsidy programs are also called buy-downs. In this example, we used what’s called a 4-3-2-1 buy-down.

There are some tax implications. While the subsidy payments are income to our employee, he receives an additional interest deduction to offset the payment. No tax gross-up is needed.

Extreme cost-of-living increase
Our third scenario is more extreme. We want to move our employee from Dallas to San Jose, California. Using the same parameters as before, the cost-of-living difference between Dallas and San Jose is $39,512. Housing is $33,374 of that difference.

Will a mortgage-subsidy program work to bridge the gap in housing prices? Even with a five-year mortgage subsidy, our employee will qualify only for a $350,000 mortgage. And the subsidy costs would be $38,703 over five years. Comparable housing in San Jose would cost $625,700. With a $350,000 mortgage and the equity from his former home (from our statistical study), our employee would be able to purchase a $440,000 home. Our employee is still thousands of dollars short in qualifying for comparable housing in San Jose.

In this instance, the employer would make up the difference with a second mortgage of $180,000. Terms of the loan would be a zero interest rate payable in five years (or earlier if employment ends).

However, not every employer has the capital available to make loans like this to employees. And some may be barred from making loans to corporate officers.

Rent instead of purchase?
Another option is to have our employee rent rather than purchase a home. The employer would pay a rental subsidy to help offset costs. The employee would not sell his home in Dallas or purchase a home in San Jose.

Let’s compare costs between this option and using a mortgage subsidy and second mortgage:

Selling former home (statistical home from cost-of-living calculation is worth $190,000); assuming 12% selling cost$22,800
New home (2% of first mortgage of $350,000)$7,000
COLA (from calculation)$39,512
Total$69,312

There may be some costs for property management for the former home in Dallas. Let’s assume that the rental income covers the mortgage payment. There would also be an opportunity cost for providing a second mortgage to the employee.

Studies indicate that a typical rental for a three- or four-bedroom house in San Jose is around $3,100 a month. Let’s also assume that our employee pays $1,000 a month toward the rental cost in San Jose. This is the approximate amount of the employee’s mortgage payment in Dallas, including property taxes.

If we provided a subsidized rental for three years using these numbers, the employer would pay $75,600 over three years.

The rental option would be more expensive, but could be attractive in the right circumstances. This option would not work for everyone; not every employee wants to rent out his former home. And suitable rentals may not be available in every community.

Now let’s look at some of the cultural or behavioral issues.

The concept of "keeping the employee whole" is dangerous.
Sometimes transferred employees believe that their employer should protect them against any change. Keeping the employee whole can be defined as "the mythological state in which everything remains the same even though circumstances may be dramatically different." The concept that the employee should be able to duplicate housing in the new location might be impossible to fulfill. Home styles can’t always be duplicated, let alone schools, climate, culture, and so on.

Rather than trying to keep your employee "whole," consider providing equivalent or "peer housing." Where do your employee's peers (i.e., families with similar incomes) live? What kinds of homes do they live in and how far do they commute to work?

The goal of your cost-of-living policy should be to make it possible for employees to live like their peers when they are transferred, not necessarily retain their former lifestyles.

Everybody upgrades.
When they move, everyone wants to upgrade. They want a bigger garage, a newer home, more living space, a better location, and a more modern kitchen. No one wants to go through the hassle of moving for the same thing. A transferred family is not prepared emotionally to settle for less, or even a duplicate of what they had.

Consider this circumstance: An employee moves from a high-cost to a low-cost area. Many times the employee ends up with a house that costs significantly more than her former home, even though "comparable" homes cost less.

The point is, even if housing prices were identical, equivalent homes would appear more expensive to a transferee and family. They want more.

Cost-of-living assistance should be temporary.
Allowances should end after a few years. Sometimes employees will argue that they should continue as long as they work in the higher-cost location. Other employees are living in the same community without any special assistance.

Cost-of-living allowances should be kept separate from compensation plans. The benefit should end if the employee moves again, resigns, or is terminated.

Is your compensation plan up-to-date?
If you aren’t competitive, this simply contributes to the problem. While you can’t change compensation systems, you can make sure your relocation benefit is competitive, objective, and effective. Providing for cost-of-living differences through your relocation program separates this issue from salary negotiations. It also provides a framework to make the most effective use of the funds available.

What was that Web address again?
Tons of information is available free from various Web sites. If you are going to use a free service to compute cost differences, you should "peek behind the curtain." How is information collected? When was the last survey completed? What communities were used for comparison?

Run several reports from different Web sites using the same scenario. Are the answers similar?

You must be certain that the information is timely and the methodology used is comparable to that of "fee" services. Even so, it is difficult to support an allowance without access to the provider. With fee-based consultants, you have this support.

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