Balance sheet approach in international compensation

Objectives of international compensation

When developing international compensation policies, an MNE seeks to satisfy several objectives. First, the policy should be consistent with the overall strategy, structure and business needs of the multinational. Second, the policy must work to attract and retain staff in the areas where the MNE has the greatest needs and opportunities. Thus, the policy must be competitive and recognize factors such as incentive for foreign service, tax equalization and reimbursement for reasonable costs. Third, the policy should facilitate the transfer of international employees in the most cost-effective manner for the firm. Fourth, the policy must give due consideration to equity and ease of administration.

The international employee will also have a number of objectives that need to be achieved from the firm's compensation policy. First, the employee will expect the policy to offer financial protection in terms of benefits, social security and living costs in the foreign location. Second, the employee will expect a foreign assignment to offer opportunities for financial advancement through income and/or savings. Third, the employee will expect issues such as the cost of housing, education of children, and home leave to be addressed in the policy.

If we contrast the objectives of the MNE and the employee, we of course see the potential for many complexities and possible problems, as some of these objectives cannot be maximized on both sides. The 'war stories' about problems in international compensation that we see in HR practitioner magazines is testimony to these complexities and problems. McNulty et al. also allude to these problems in their studies of expatriation, particularly in the Asia Pacific region.16

However, if we take away the specialist jargon and allow for the international context, are the competing objectives of the firm and the employee fundamentally different from that which exists in a domestic environment? We think not. We agree with the broad thrust of an influential article by Milkovich and Bloom17 which argues that firms must rethink the traditional view that local conditions dominate international compensation strategy. This is again another application of the ongoing balancing act between global standardization and local customization. We will return to these issues at the end of the chapter after we have covered some of the technical aspects and complexities of compensation in an international context.

KEY COMPONENTS OF AN INTERNATIONAL COMPENSATION PROGRAM FOR EXPATRIATES

The area of international compensation is complex primarily because multinationals must cater to three categories of employees: PCNs, TCNs and HCNs. In this section, we discuss key components of international compensation as follows.

Base salary

The term base salary acquires a somewhat different meaning when employees go abroad. In a domestic context, base salary denotes the amount of cash compensation serving as a benchmark for other compensation elements (such as bonuses and benefits). For expatriates, it is the primary component of a package of allowances, many of which are directly related to base salary (e.g. foreign service premium, cost-of-living allowance, housing allowance) as well as the basis for in-service benefits and pension contributions. It may be paid in home or local country currency or a combination of both. The base salary is the foundation block for international compensation whether the employee is a PCN or TCN. Major differences can occur in the employee's package depending on whether the base salary is linked to the home country of the PCN or TCN, or whether an international rate is paid. (We will return to this issue later in the chapter.)

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Foreign service inducement and hardship premium

Parent-country nationals often receive a salary premium as an inducement to accept a foreign assignment, as well as a hardship premium to compensate for challenging locations. Under such circumstances, the definition of hardship, eligibility for the premium, and amount and timing of payment must be addressed. For example, where a host country's work week may be longer than that of the home country, a differential payment may be made in lieu of overtime, which is not normally paid to PCNs or TCNs. In cases in which hardship is determined, US firms often refer to the US Department of State's Hardship Post Differentials Guidelines to determine an appropriate level of payment. As a number of researchers in this field have noted over many decades18 making international comparisons of the cost of living is problematic. It is important to note, though, that these payments are more commonly paid to PCNs than TCNs. Foreign service inducements, if used, are usually made in the form of a percentage of salary, usually 5 to 40 per cent of base pay, but are also sometimes offered as a lump-sum incentive (i.e. as a one-off payment made at some point during an assignment). Such payments vary, depending upon the assignment location, tax consequences, and length of assignment.

Allowances

Issues concerning allowances can be very challenging to a firm establishing an overall compensation policy, partly because of the various forms of allowances that exist. In this section we will discuss the six most common allowances.

Cost-of-living allowance. The cost-of-living allowance (COLA), which typically receives the most attention, involves a payment to compensate for differences in expenditures between the home country and the foreign country. COLA payments are intended to compensate for cost differentials between an expatriate's home and host country, for example, the costs of transportation, furniture and appliances, medical, alcohol and tobacco, automobile maintenance and domestic help. Family size is the predominant method for determining COLA payments, with increments provided for each child. Often this allowance is difficult to determine, so companies may use the services of organizations such as Mercer (a US-based firm)19 or ECA International (based in Britain).20 These firms specialize in providing COLA information on a global basis, regularly updated, to their clients. The COLA may also include payments for housing and utilities, and discretionary items.21 Various COLA indices exist, which, for example, allow an American to live like an American in Paris or which presume that the American will adapt to the assignment location by adjusting to the local life style and international living costs.

Housing allowance. The provision of a housing allowance implies that employees should be entitled to maintain their home-country living standards (or, in some cases, receive accommodation that is equivalent to that provided for similar foreign employees and peers). The amount of housing allowance is determined predominantly by family size, and to some extent job level. Other alternatives include company-provided housing (either mandatory or optional); a fixed housing allowance across a particular job level, with the expatriate 'topping up' according to personal preferences; or assessment of a portion of income, out of which actual housing costs are paid. Housing issues are often addressed on a case-by-case basis, but as a firm internationalizes, formal policies become more necessary and efficient. Financial assistance and/or protection in connection with the leasing of an expatriate's former residence is offered by many MNEs, but less so for selling a house as many MNEs encourage their employees to retain a presence in their home country real estate market. Those in the banking and finance industry tend to be the most generous, offering assistance in sale and leasing, payment of closing costs, payment of leasing management fees, rent protection and equity protection. Generally, TCNs tend to receive these benefits less frequently than PCNs.

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a foreign rider such timing of be longer , which is :ms often

Home leave allowances. Many MNEs also have a provision for home leave allowances

where employers cover the expense of one or more trips back to the home country each year. The primary purpose of paying for such trips is to give expatriates the opportunity to renew family and business ties, thereby helping them to minimize adjustment problems when they are repatriated. Although firms traditionally have restricted the use of leave allowances to travel home, some firms give expatriates the option of applying home leave to foreign travel rather than returning home. Firms allowing use of home leave allowances for foreign travel need to be aware that expatriate employees with limited international experience who opt for foreign travel rather than returning home may become more homesick than other expatriates who return home for a 'reality check' with fellow employees and friends. Without the benefit of returning home to mix with employees and friends it is possible to idealize what they remember of their experience at work and home and fail to come to a measured judgment of what is good and bad in both their host and home environments. Overall, it would seem prudent for MNEs to take the view that home leave allowances should normally be used for the purpose they are provided - to give employees and their families the opportunity to renew family and business ties, thereby increasing the probability of reduced adjustment problems when they are repatriated.

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Education allowances. The provision of education allowances for the children of expatriates is frequently an integral part of an international compensation policy. Allowances for education can cover items such as tuition (including language classes), application and enrolment fees, books and supplies, meals, transportation, excursions and extra-curricular activities, parent association fees, school uniforms and, if applicable, room and board. Although school uniforms are not common in the USA, it is common practice (and in many countries compulsory) for school children to wear uniforms, particularly in international schools. PCNs and TCNs usually receive similar treatment concerning educational expenses, but the level of education provided for and the adequacy of local public schools versus international schools may present problems for multinationals. International schools (e.g. United World College of South East Asia, British International School Shanghai) are far more expensive than local public schools but are preferred by many expatriates because these schools follow the home-country curriculum and cater to a globally diverse student body more capable of supporting 'third culture kids'. The cost of local and international schools for dependent children from kindergarten through to high school are typically covered by the employer ORC reports that 95 per cent of MNEs contribute to the educational expenses of expatriate children.22 However, there may be restrictions depending on the age of children (pre-school, day care and university are typically not covered), availability of school places, and their fees. In a number of countries attendance at schools in the host location may be seen as unsuitable and the MNE may cover (or contribute towards) the costs of children attending a private boarding school elsewhere (e.g. the costs of room and board as well as other transportation costs to cover parental visits and school holiday travel).23 The costs of attendance at a university may also be provided for by multinationals, when deemed necessary, but this is rare.

Relocation allowances. Items typically covered by relocation allowances include moving, shipping and storage charges; temporary living expenses; subsidies regarding appliance or car purchases (or sales); and down payments or lease-related charges. Allowances regarding perquisites (cars, drivers, club memberships, servants24 and so on) may also need to be considered (usually for more senior positions, but this varies according to location). These allowances are often contingent upon tax-equalization policies and practices in both the home and the host countries. For example, in most Western countries a driver is considered a luxury, only available to very senior managers. In developing economies a driver is economical in terms of cost, effectiveness and safety. Apart from the expectation that managers use drivers, parking is frequently chaotic in developing countries (especially in large cities) and the driver also performs the function of a parking attendant. In some developing countries it is quite common for the police to

arrest drivers involved in traffic accidents and leave them in detention while responsibility and damages are assessed. Such a risk is unacceptable to many MNEs which do not allow their expatriate employees to drive at all in specific developing countries and provide local drivers for both the expatriate and spouse.

Spouse assistance. Increasingly, many MNEs are also offering spouse assistance to help guard against or offset income lost by an expatriate's spouse as a result of relocating abroad. Payments, on average, are capped at US$7000 per family but vary according to region. Although some MNEs may pay a one-time allowance to make up for a spouse's lost income (averaging US$11000 per family according to ORC25), US multinationals are beginning to focus on providing spouses with employment opportunities abroad, either by offering job-search assistance, career counseling, cultural orientation, resume/CV preparation, work permit assistance and language tuition, or in more unusual cases employment in the MNE's foreign business (subject of course to a work visa being approved by the host country government for this purpose).

To summarize, MNEs generally pay allowances in order to encourage employees to take international assignments and to keep employees 'whole' (i.e. relatively comparable) to home standards. We will present more about this concept later in the chapter.

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Benefits

The complexity inherent in international benefits often brings more difficulties than when dealing with compensation. Expatriate 'benefits' includes health care, pension plans/social security, life insurance, child allowances and profit sharing/stock option plans.

Pension plans are very difficult to deal with country-to-country as national practices vary considerably. Transportability of pension plans/social security and medical coverage benefits are very difficult to normalize. Therefore, MNEs need to address many issues when considering benefits, including:

· Whether or not to maintain expatriates in home-country programs, particularly if the multinational does not receive a tax deduction for it.

· Whether MNEs have the option of enrolling expatriates in host-country benefit programs and/or making up any difference in coverage.

· Whether expatriates should receive home-country or are eligible to receive host-country social security benefits.

Most US PCNs typically remain under their home-country benefit plan, with the exception of medical benefits: more than half of the MNEs surveyed by ORC assign their expatriates to an international healthcare plan. In some countries, expatriates cannot opt out of local social security programs. In such circumstances, the firm normally pays for these additional costs. European PCNs and TCNs enjoy portable social security benefits within the European Union. Laws governing private benefit practices differ from country to country, and firm practices also vary. Not surprisingly, multinationals have generally done a good job of planning for the retirement needs of their PCN employees, but this is generally less the case for TCNs.26 There are many reasons for this: TCNs may have little or no home-country social security coverage; they may have spent many years in countries that do not permit currency transfers of accrued benefit payments; or they may spend their final year or two of employment in a country where final average salary is in a currency that relates unfavorably to their home-country currency. How their benefits are calculated and what type of retirement plan applies to them may make the difference between a comfortable retirement in a country of their choice or a forced and financially less comfortable retirement elsewhere.

In addition to the already discussed benefits, multinationals also provide vacations and special leave. Included as part of the employee's regular vacation, annual home leave usually provides airfares for families to return to their home countries. Rest and rehabilitation leave is also frequently available if the conditions of the host country are clearly below the standards of the home country. Typically, rest and rehabilitation leave provides the employee's family with paid airfares to a more comfortable location near the host country. In addition to rest and rehabilitation leave, emergency provisions are available in case of a death or illness in the family. Employees in hardship locations generally receive additional leave expense payments and rest and rehabilitation periods.

APPROACHES TO INTERNATIONAL COMPENSATION OF EXPATRIATES

There are two main options in the area of international compensation - the Going Rate Approach (also referred to as the Market Rate Approach) and the Balance Sheet Approach (sometimes known as the Build-up Approach). In this section we describe each approach and discuss the advantages and disadvantages inherent in each approach.27

The going rate approach

The key characteristics of this approach are summarized in Table 8.1. With this approach, the base salary for the international transfer is linked to the salary structure in the host country. The multinational usually obtains information from local compensation surveys and must decide whether local nationals (HCNs), expatriates of the same nationality or expatriates of all nationalities will be the reference point in terms of benchmarking. For example, a Japanese bank operating in New York would need to decide whether its reference point would be local US salaries, other Japanese competitors in New York, or all foreign banks operating in New York. With the Going Rate Approach, if the location is in a low-pay county, the multinational usually supplements base pay with additional benefits and payments.

TABLE 8.1 Going rate approach

Based on local market rates Relies on survey comparisons among:

· Local nationals (HCNs)

· Expatriates of same nationality

· Expatriates of all nationalities

Compensation based on the selected survey comparison

Base pay and benefits may be supplemented by additional payments for low-pay countries

There are advantages and disadvantages of the Going Rate Approach, summarized in Table 8.2. The advantages are: there is equality with local nationals (very effective in attracting PCNs or TCNs to a location that pays higher salaries than those received in the home country); the approach is simple and easy for expatriates to understand; expatriates are able to identify with the host country; and there is often equity among expatriates of different nationalities.

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Advantages Disadvantages • Equality with local nationals • Simplicity • Identification with host country • Equity among different nationalities • Variation between assignments for same employee • Variation between expatriates of same nationality in different countries • Potential re-entry problems TABLE 8.2 Advantages and disadvantages of the going rate approach

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The disadvantages of the Going Rate Approach include: First, there can be variation between assignments for the same employee. This is most obvious when we compare an assignment in an advanced economy with one in a developing country, but also between assignments in various advanced economies where differences in managerial salaries and the effect of local taxation can significantly influence an employee's compensation level using the Going Rate Approach. Not surprisingly, individual employees are very sensitive to this issue. Second, there can be variation between expatriates of the same nationality in different locations. A strict interpretation of the Going Rate Approach can lead to rivalry for assignments to locations that are financially attractive and little interest in locations considered financially unattractive. Finally, the Going Rate Approach can pose problems upon repatriation when the employee's salary reverts to a home-country level that is below that of the host-country. This is not only a problem for firms in developing countries, but also for MNEs from many countries where local managerial salaries are well below that of the USA, which has long been the world market leader in managerial salaries, although the gap between US and some European salaries has been narrowing.28

The balance sheet approach

The key characteristics of this approach (which is the most widely used approach for international compensation) are summarized in Table 8.3. The basic objective is to 'keep the expatriate whole' (that is, maintaining relativity to PCN colleagues and compensating for the costs of an international assignment29) through maintenance of home-country living standard plus a financial inducement to make the package attractive. This approach links the base salary for expatriates to the salary structure of the relevant home country. For example, a US executive taking up an international position would have his or her compensation package built upon the US base-salary level rather than that applicable to the host country. The key assumption of this approach is that foreign assignees should not suffer a material loss due to their transfer, and this is accomplished through the utilization of what is generally referred to as the Balance Sheet Approach. According to Reynolds:

The balance sheet approach to international compensation is a system designed to equalize the purchasing power of employees at comparable position levels living overseas and in the home-country and to provide incentives to offset qualitative differences between assignment locations.30

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TABLE 8.3 The balance sheet approach

· Basic objective is maintenance of home-country living standard plus financial inducement

· Home-country pay and benefits are the foundations of this approach

· Adjustments to home package to balance additional expenditure in host country

· Financial incentives (expatriate/hardship premium) added to make the package attractive

· Most common system in usage by multinational firms

There are four major categories of outlays incurred by expatriates that are incorporated in the Balance Sheet Approach:

1 Goods and services - home-country outlays for items such as food, personal care, clothing, household furnishings, recreation, transportation and medical care.

2 Housing - the major costs associated with housing in the host country.

3 Income taxes - parent-country and host-country income taxes.

4 Reserve - contributions to savings, payments for benefits, pension contributions, investments, education expenses, social security taxes, etc.

Where costs associated with the host-country assignment exceed equivalent costs in the parent country, these costs are met by both the MNE and the expatriate to ensure that parent-country equivalent purchasing power is achieved.

Employee: Brian Smith Position: Marketing Manager Country: New Euphoria Reason for change: New Assignment Effective date of change 1 February 2013 Amount Paid in Australian Paid in local Item A$ PA dollars AS PA currency NES PA Base salary 200000 100000 150000 Cost of living allowance 50000 75000 Overseas service premium (20%) 40000 40000 Hardship allowance (20%) 40000 40000 Housing deduction (7%) -14000 -14000 Tax deduction -97 000 -97000 TOTAL 219000 69000 225000 COLA Index = 150 TABLE 8.4 Expatriate compensation worksheetTable 8.4 shows a typical spreadsheet for an expatriate assignment using the Balance Sheet Approach. In this example, an Australian expatriate is assigned to a hypothetical country called New Euphoria which has a Cost-of-Living-Index of 150 relative to Australia and an exchange rate of 1.5 relative to the Australian dollar. In addition to a foreign service premium, a hardship allowance is also payable for this location. Housing is provided by the MNE, and a notional cost for this is recognized by a 7 per cent deduction from the package, along with a notional tax deduction (we discuss taxation later in the chapter). The expatriate can see from this spreadsheet what components are offered in the package and how the package will be split between Australian currency and New Euphoria currency.

There are advantages and disadvantages of the Balance Sheet Approach, summarized in Table 8.5. There are three main advantages. First, the Balance Sheet Approach provides equity between all foreign assignments and between expatriates of the same nationality. Second, repatriation of expatriates is facilitated by this emphasis on equity with the parent country as expatriate compensation remains anchored to the compensation system in the parent country. Third, this approach is easy to communicate, as Table 8.4 illustrates.

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Advantages

TABLE 8.5 Advantages and disadvantages of the balance sheet approach

Equity

· Between assignments

· Between expatriates of the same nationality

Facilitates expatriate re-entry Easy to communicate to employees

Disadvantages

· Can result in great disparities

· Between expatriates of different nationalities

· Between expatriates and local nationals

· Can be quite complex to administer

There are two main disadvantages of the Balance Sheet Approach. First, this approach can result in considerable disparities - both between expatriates of different nationalities and between PCNs and HCNs. Problems arise when international staff are paid different amounts for performing the same (or very similar) job in the same host location, according to their different home base salary. For example, in the Singapore regional headquarters of a US bank, a US PCN and a New Zealand TCN may perform the same (or similar) banking duties but the American will receive a higher salary than the New Zealander because of the differences in US and New Zealand base-salary levels. As noted above, differences in base-salary levels can also cause difficulties between expatriates and HCNs. Traditionally, this has referred to the problem of highly paid PCNs being resented by local HCN employees because these 'foreigners' are perceived as being excessively compensated (and because they are blocking career opportunities for locals).

However, feelings of resentment and inequity can also run in the other direction. For instance, as indicated above, the USA has the highest level of managerial compensation in the world. Thus, a multinational that establishes a subsidiary in the USA (or acquires a US business) may find that if it uses a Balance Sheet Approach, its expatriates may be substantially underpaid compared to local American employees. While the logic of the balance sheet states that being tied to the home country assists in repatriation because the expatriate identifies with the home country, research in equity theory31 suggests that employees do not always assess compensation issues in a detached way.

The issue of base salary differences is also a concern for US employees working for foreign firms operating in the USA. Many non-US multinationals are reluctant to pay high US salaries to US employees who are offered international assignments" (as HCNs into the firm's home-country operations, or as TCNs in a regional subsidiary). US employees are equally reluctant to accept the lower salaries paid in the firm's home country. Thus, the Balance Sheet Approach can produce disparities and may also act as a barrier to staff acceptance of international assignments. A second problem with the Balance Sheet Approach is that while this approach is both elegant and simple as a concept, it can become quite complex to administer. Complexities particularly arise in the areas of tightly integrated private and government fund transfers (e.g. taxes and pensions).

A third emerging approach to international compensation: 'Local Plus' ^

Over the past decade, a third approach to international compensation, summarized in Table 8.6, and called Local Plus has begun to emerge, particularly in the Asia Pacific region. A Local Plus approach is one in which expatriate employees are paid according to the prevailing salary levels, structure, and administration guidelines of the host location, plus provided 'expatriate-vpe' benefits such as assistance with transportation, housing, and dependents' education in rec-nition of the employee's 'foreign' status. Benefits may be paid in-kind (directly by the MNE) s add-ons to local salary levels at a grossed-up rate to account for host taxes. Local Plus