Cost of Living Allowance (COLA Guide)

Establishing a salary package for expatriates on international assignments can be done in a number of different ways. There is not necessarily any right or wrong approach. However, the package should incorporate, where relevant, any adjustments to reflect the cost of living in the assignee’s host country.

In this guide for employers, we look at the cost of living allowance (COLA), what it is, how it is calculated and what factors can affect this.

 

What is a cost of living allowance (COLA)?

When establishing a salary package for an employee undertaking either short or long-term overseas assignments, many employers will include a cost-of-living allowance (COLA) as part of the assignment compensation package.

The COLA is to compensate the assignee where the cost of goods and services are higher in the host location than they would be in their home country. Most employers will adopt what’s known as the home-based approach. The basis of this approach is to match the employee’s home-country purchasing power while on assignment in the host location, so they are no better or worse off.

In order to achieve this, a comparison of the cost of living in the home and host city is made, where the COLA represents the difference in cost of living between the assignee’s home and host location.

The COLA is also sometimes described as a ‘goods and services differential’, where factoring in this differential ensures that international assignees will always broadly have the same amount of spendable income in their pockets, no matter what country or region they are working in.

 

Why apply a cost of living allowance (COLA)?

Knowing that any increase in the cost of living will be met by their employer is more likely to encourage employees to accept overseas assignments, providing financial reassurance that they will be financially comfortable meet while abroad. This can be especially important if the assignee is travelling to a region with a higher cost of living or where the home currency is weak against the host currency.

By adopting a clear and fair approach, giving individuals much needed peace of mind, overseas assignees are also more likely to succeed in their assignment, thereby significantly reducing the risk, and cost, of early repatriation.

 

How is a cost of living allowance (COLA) calculated?

To calculate the cost of living allowance (COLA) requires the following:

• Determine the notional home salary
• Determine the home spendable income
• Determine the cost of living index (COLI) for the home and host cities
• Deduct the home spendable income from the host spendable income

 

Determine the notional home salary

When utilising the home-based approach to calculate the cost of living allowance (COLA), you will need to use a balance sheet that starts with the employee’s notional home salary. This is the typical salary an employee would get paid in their home country for doing the same job.

This notional salary is then netted down by deducting hypothetical tax and national insurance contributions. This will give you a notional home net salary.

 

Determine the home spendable income

A proportion of the resulting notional home net salary is then protected for the difference in cost of living. In order to establish how much of this salary should be protected, you can utilise spendable tables or calculators derived from government statistics and vary according to nationality, family size and salary.

These tables calculate the amount of money, or portion of an employee’s home salary, typically spent to maintain his or her standard of living. This is known as the home spendable income.

The home spendable income is based on different expenditure categories, including day-to-day purchases for goods and services such as:

• Food and groceries, eating in or eating out
• Clothing and personal care
• Tobacco and alcohol
• Utilities and furnishings
• Medical expenses not covered by insurance
• Motor expenses, including fuel, insurance and vehicle maintenance
• Public transportation
• Domestic services, including childcare
• Recreational activities

 

Some employers will use a fixed percentage, such as 60% of the net salary, rather than spendable tables. Either way, you must decide the proportion of spendable income to which you will apply the cost of living allowance (COLA).

Any benefits provided by you as the employer, or any fixed costs you are covering while the employee is on assignment, will also help to determine what is spendable. These can include housing, healthcare, travel, utilities and tuition fees for dependents. You will need to exclude any expenditure items that are already covered by you.

 

Determine the Cost of Living Index (COLI) for the home and host cities

Once the home spendable income has been established, the cost of living index (COLI) is applied. This involves applying data from an independent data provider to determine the COLI for the home and host cities.

The COLI is a theoretical price index that measures relative cost of living over time or regions. It essentially measures the cost of a market basket of goods and services in cities around the world including, for example, food and groceries, clothing, tobacco and alcohol, furnishings, medical expenses, motor expenses, public transport, domestic services and recreational activities.

Assuming the COLI uses a baseline of 100 for the assignee’s home city: if the market basket of goods and services for the host city has an index greater than 100 that indicates the host location has a higher cost of living than the home location. If the index is less than 100, that means the host location has a lower cost of living than the home location.

By way of example, if the home city is London (UK), taking a central reference point of 100, and the host location is New York (US) with a COLI of say 120, this means the host location is 20% more expensive than the home location.

 

Deduct the home spendable income from the host spendable income

The home spendable income that has been adjusted for cost of living is referred to as the host spendable income. The host spendable income is comprised of two parts: the amount the assignee would have spent on goods and services at home, ie; the home spendable, plus a cost of living allowance (COLA), if applicable.

This is essentially the host-location currency equivalent of the home-country spendable income amount supplemented by the cost of living allowance (COLA).

In the above example, where the host location (New York) is 20% more expensive than the home location (London), an employee with a net spendable income of £50,000 would need 120% of that amount, so an extra £10,000 per year, to maintain the same standard of living in New York as in London. This would mean the COLA is calculated at £10,000.

However, most employers would spread this sum across an annual pay period. So for employers with a monthly payroll, the employer would divide a COLA of £10,000 by the year’s 12 pay periods.

To arrive at the total gross assignment package, the portion of home net salary not indexed is added back to the host spendable, along with any assignment-related allowances and benefits, then grossed up for host country tax.

 

What factors can affect the cost of living allowance?

As the cost of living allowance (COLA) is the variable portion of the composite host-location spendable income amount, changes to domestic and host-country expenditure patterns can influence the amount of adjustment needed.

However, in addition to any changes to the portion of the salary which the cost of living index is applied to, there are two additional factors which affect the COLA: currency fluctuations and price changes in the home and host countries.

As the cost of living index (COLI) and the exchange rate are linked, any variances to the exchange rate will also affect the index and, in turn, the COLA. For example, if the home location currency weakens against the host location currency, more home currency will be needed to maintain the same standard of living and the COLA will increase.

In respect of price changes, the effect on the COLA will depend on the difference in price changes between the home and host country. If inflation in the home location is higher than in the host location, the difference in cost of living between the two countries is reduced and the COLA will decrease.

 

Can a cost of living allowance (COLA) be negative?

As the cost of living can be either higher or lower in the host location, the cost of living allowance (COLA) can be either positive or negative. Typically, however, the COLA adjustment is an increase in income to keep up with the cost of living.

In cases where the cost of living index (COLI) is less than 100 and the host location is less expensive than the home location, most employers will allow their assignees to maintain the higher purchasing power and not require a reduction in salary, thereby effectively increasing their standard of living in the host location.

However, as an employer, you should always be clear and transparent about your approach to any negative COLA, and how this has been calculated, so as to avoid any unnecessary cause for concern amongst your international assignees.

You should also regularly review the COLI and current exchange rates and make any necessary adjustments. It is equally as important that the assignee understands that the COLA is subject to review and may fluctuate during the course of their overseas assignment, especially where this is long-term.

 

COLA FAQs

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Legal disclaimer

The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal advice, nor is it a complete or authoritative statement of the law, and should not be treated as such. Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission. Before acting on any of the information contained herein, expert legal advice should be sought.