Mobility Basics - Why do Cost of Living indices change?

Cost of Living indices enable multinational companies to compare living costs between home and host locations and calculate appropriate remuneration packages for when they send their employees on international assignments. The intention here is that the employee is neither better nor worse off than if they had remained at home. 

But, as economies never stand still, Cost of Living indices only ever reflect the circumstances at the point of time the data was collected, and so the majority of companies will review the Cost of Living Adjustment (COLA) at the same time as the salary review, to ensure that the purchasing power of their assignees is protected. 

The two factors that affect an index are exchange rates and price changes in both the home and host locations. Let’s look at how each element can impact the Cost of Living index:

Exchange rates 

It is essential to know relative currency values in order to compare prices in the home and host locations and thus Cost of Living indices are directly linked to exchange rates as illustrated below. 

When updating a Cost of Living index for exchange rates, the index could increase or decrease: 

If the home country currency lost value against the host country currency, the index will increase as more home country currency will be needed to buy the same amount of host country currency:

Conversely, if the home country currency has strengthened against the host country currency, the index will decrease as less home country currency will be needed to buy the same amount of host country currency:

Currency fluctuations can be a major challenge for both assignees and those responsible for administering their packages. We discussed this in a previous blog and also in an in-depth webinar.

Price changes

ECA’s shopping basket is designed specifically to measure expatriate expenditure on assignment and contains over 170 key items representative of daily goods and services. Therefore, the index is affected by the relative changes in the home and host prices as illustrated below:

If prices in the host location increase more than in the home location, the index will increase.

And if prices in the home location increase more than in the host location, the index will decrease.

Often assignees tend to be unaware of how prices are increasing in their home country while on assignment, so they are often surprised to see the index decrease when they have seen prices either rising (or remaining stable) in host location shops. Therefore, they may need to be reminded that living costs are also increasing for their peers back home and that the index is designed to maintain the standard of living that they would be experiencing now were they not on assignment. If a company wishes to account for the effect of home inflation on an assignee’s pay, generally this is done by reviewing the assignee’s notional home salary – as they would for the assignee’s home country peers. Options for how to review the salary of expatriates are captured in this blog.

Example

Now that we have discussed the theory of index movement, let’s put it in practice and look at the following example focusing on an assignment from Central London to Luanda, Angola:

In March 2019 ECA had measured a standard index of 142.5 at an exchange rate of GBP 1 = AOA (Angolan kwanza) 411.9. 

Six months later, in September 2019, ECA had measured a standard index of 141.3 at an exchange rate of GBP 1 = AOA 444.7.

ECA measured the following changes over that period:

Let’s look at this in more detail:

Exchange rates: in March 2019 the GBP was buying AOA 411.9, but by September 2019 the GBP had strengthened against the AOA and was buying AOA 444.7. Therefore, assignees needed less home country currency to buy the same amount of AOA, which had a negative impact on the index. So, if we update the March 2019 index for exchange rate movements only, we obtain the following:

March 2019 index	142.5 @ GBP 1 = AOA 411.9
New exchange rate	GBP 1 = AOA 444.7
Formula	= original index x original exchange rate / new exchange rate (= 142.5 x 411.9 / 444.7)
Index updated for FX rates	= 132.0

Price changes: We now need to look at the effect of the price changes in the home and host countries for the same six-month period. ECA measured that prices for the shopping basket (not official inflation) in Central London had increased by 0.3%, whereas prices in Luanda had increased by 7.4%. As prices increased more in Luanda than in Central London this had a positive impact on the index. The index is updated for price changes as follows: