Localization's Hidden Costs

​Before replacing a traditional expatriate package with a localization arrangement, weigh the options.

In the early 1990s, a U.S. multinational company sent a highly compensated American employee to France under the company’s “permanent transfer” policy. It was understood that the employee would not be an expatriate but instead would be treated as a French local hire. The employee received a buyout of his U.S. pension as well as relocation assistance and a local French salary. He began making regular contributions to the French social security system and local pension plan.

Ironically, because of the high cost of French benefits and social security, the employee’s new local package did not represent a substantial savings for the company when compared with the original expatriate package.

Seven years later, the company determined it needed the employee back in the United States. Since he was now a French employee, this meant an international assignment to the United States from France. The result? The American began working in the United States but has been treated as an expatriate from France, complete with a French base salary, French social security contributions (these are substantial), a cost-of-living allowance, housing assistance—and all the other assignment-related benefits normally offered to expatriates.

Now, the employee is planning for retirement—in the United States. So the organization has decided to “localize” the American employee in his own country! The complications and the costs are enormous.

HR directors, under pressure to trim the costs of international assignment programs, are increasingly turning to localization. The KPMG International Assignment Policies and Practices Survey from 2003 showed that 78 percent of participants had some form of localization policy. And a recent Cendant Mobility survey showed that, in 2004, 63 percent of participants expected an increase in the number of “localized transfers,” up from 51 percent in 2002.

The general idea of localization is to remove the many expensive allowances and perks that normally go along with an international assignment and to set the employee’s remuneration on a par with local standards and practices. Given that a local compensation package is often perceived as less costly than an expatriate one, it’s believed that localization always reduces costs and is easy to implement.

In fact, the appeal of near-term reductions in assignment program costs can lead to shortsighted decisions that can come back to haunt the company, the employee or both.

A Definition With a Difference

The term “localization” has various meanings. For some, it means removal of expatriate allowances but retention of the home-country base salary and long-term benefits such as social security and pension plans. For others, it means not only removal of expatriate allowances but also the shifting of the employee’s base salary to host-country levels, with long-term benefits remaining tied to the home country. A third approach to localization involves removing the allowances and shifting not only the salary but also the employee’s long-term benefits—and the employment relationship itself—to the host country.

While the first two approaches to localization appear simplest, they do not address complexities and nuances that can lead to substantial problems. The third approach is closest to what is arguably the most appropriate definition of localization.

To clarify the approaches, it can be helpful to regroup them under the terms “localization” and “host-based compensation”:

• Localization is the process of transforming an expatriate remuneration package (including base salary, incentive compensation, risk benefits, perks, social security and retirement plans) into one that is identical to that available to locally hired employees, with the understanding that the employee does not intend to return to his or her original country of employment.

• Host-based compensation is the use of assignment-location peer compensation levels to determine an expatriate’s near-term remuneration (base salary, incentive compensation and perks) while maintaining the assignee’s long-term remuneration (such as social security and retirement benefits) in the home country, with the understanding that the employee does intend to return eventually to his or her original country of employment.

The fundamental distinction between the two definitions is whether or not it is intended that the employee return to the home country. The answer not only affects participation in benefit plans but also impacts important personal financial decisions such as retirement and estate planning, and whether to purchase a home in the host location. (See “Terms of Deployment”.)

A typical localization policy consists of a few paragraphs at the end of an international assignment policy, calling for a phaseout of expatriate allowances and benefits once the assignee has spent four or five years at the host location, and the American expatriate would be switched over to a local base salary. Presumably, during a transition phase, expatriate benefits would be eliminated gradually, leaving the employee on a local package.

But consider some of the factors this approach does not address:

• As a U.S. citizen, the employee will have to file a U.S. tax return and may even have to pay some federal taxes in addition to taxes paid to the host country. Should the company help the employee with those obligations?

• Will an employee who is switched over to the local payroll be able to continue contributing to a qualified pension or savings plan such as a 401(k) plan? If the employee is still entitled to participate in such plans, is it appropriate that those contributions are now being calculated on the basis of a host-country salary rather than a U.S. salary?

• If the employee is prevented by plan rules from participating in those retirement arrangements and his or her funds must be withdrawn, who will pay the likely tax penalty?

• If the employee retains funds in home-country qualified plans, the income generated by those funds, though not normally taxable at home, might be considered taxable in the host country. Will the company address that?

• How will the employee’s years of service in the United States count toward retirement benefits in the host country?

• What if the employee cannot secure permanent residence in the host country?

• The employee will almost inevitably retire with split participation in the U.S. and host-country social security systems. Will that cause the employee to be subject to a reduction in benefits? How can the employee know what his or her final social security income will be? Who will help the employee apply for benefits under a totalization agreement (if one exists)? (Totalization agreements are treaties between countries that allow expatriate employees to avoid having to contribute to both the home- and the host-country social security systems, normally for a period of five years.)

Failure to address those and other questions can make localization policies of little value. The answers are tied to the employee’s circumstances and assignment, including the home and host countries involved, and the employee’s personal financial concerns, retirement plans and family situation.

The question of permanence—whether the employee intends to return to his or her country of origin—is crucial because it affects long-term benefits and therefore the reversibility of the decision.

Host-based pay, under which the assignee is expecting to return home eventually, generally includes some form of ongoing participation in long-term benefits in the home country via vehicles such as “shadow salaries” or “notional pay.” This facilitates repatriation in that only the near-term compensation elements, such as base pay and incentive compensation, have been changed during the assignment. The employee has continued to participate in pensions, social security and other long-term plans on a basis similar to what would have occurred had he or she stayed at home.

Uneven Compensation

Both localization and host-based compensation also face the simpler challenge of dealing with variations among compensation levels around the world.

A majority of expatriates on assignment today hail from North America, Western Europe, Australia or Japan. Their compensation levels, relative to those in most of the rest of the world, are quite high, and their benefit plans are usually sophisticated and reliable.

Except for those regions and countries, however, where would an employee from an advanced industrial nation agree to be localized? Is it plausible to envision an employee from a high-paying country agreeing to localization or host-based pay in a place where the total compensation is substantially lower than at home?

One important factor affecting this issue is whether it’s the employer or the employee who is the driving force behind the localization. An expatriate employee with a strong desire to remain in the host country beyond the planned length of assignment (perhaps because he or she married a local) is much more amenable to localization and the remuneration changes that accompany it than an employee who perceives that he or she is staying at the assignment location for the benefit of the company.

Putting these self-driven localizations aside, it is easy to envision a list of more than 100 countries where most North Americans and their European counterparts would simply refuse to “go local.” Faced with such a refusal, the organization may be forced into a choice of either ignoring policy or risking the loss of the employee altogether.

How To Go About It

This does not mean that localization has no place in the expatriate dialogue today. But it does mean that it must be approached in a disciplined fashion, one that is focused on each individual employee’s situation and allows for the many complexities to be addressed and resolved. Among the major steps:

• Determine the suitability of both the employee and the location. Some employees simply should not be candidates for this process. Employees who have shown no interest in the local language and culture, and those with substantial financial connections in their home countries (vacation homes, businesses, etc.), are probably not good candidates for localization.

  There are also many home-host combinations that should cause program managers to pause before proceeding with localization. As a general rule, the process will be much more difficult if it involves employees from an advanced industrial nation—a European Union country, for example—going to one of the lesser-developed countries. Many such nations have lower standards of living; less-sophisticated social security, savings and pension systems; and less-reliable currencies. All of those factors can spell trouble for the long-term planning crucial to localization.

• Address legal issues at home and regarding the host country. Such issues generally have to deal with employment law or immigration, and they pertain to both the home and host countries. It is necessary—prior to changing an employee’s status—to review all contracts, letters of understanding, collective agreements, qualified plan rules, and pertinent legislation dealing with severance and termination. In some situations, even though the employee is employed in the host location, he or she might still be entitled to severance payments from the original home-country organization.

  Given that localization, as defined here, is a permanent move, it will be necessary to start down the often long and tortuous path toward legal permanent residency, or perhaps ultimately citizenship. Companies and employees contemplating a move should consult with qualified attorneys in their home and host countries.

• Establish a local remuneration package. As tempting as it is to mix in special benefits, the remuneration package should be sustainable and defensible over the long term—that is, essentially indistinguishable from a package that might be offered to a local with similar skills and experience. In comparing the costs of an expatriate package and the new local package, be sure to include all local benefits; many countries put more emphasis on noncash perks, which need to be included in the comparison. Also, make an honest accounting of any residual expatriate benefits, such as transitional schooling or tax assistance.

• Help the employee review personal financial implications. Countless personal financial issues are raised when changing one’s country of residence. Everything from wills and estate planning to home ownership, tax filing obligations and retirement planning can be directly and often dramatically affected. A localizing employee should have a comprehensive financial review done to highlight any hidden risks and to get help in adjusting retirement plans and ultimately making an informed decision about the process.

• Confirm and document the arrangement. For expatriate program managers, some of the most unpleasant conversations begin with the words, “I was promised … .” Whatever the terms of the final deal, it is crucial that it be documented and filed. This includes acknowledgements by the employee that he or she has been briefed on the expected tax and personal financial implications of the arrangement, that the employee understands his or her tax filing obligations, and, perhaps most important, that the employee understands that the arrangement is intended to be permanent. This documentation should be comprehensive and should explain key elements of the employment relationship.

Raising the Bar For Everyone

While it can be useful in specific situations, localization is not the cost-saving panacea that so many have made it out to be.

In a sense, it is in the employer’s and the employee’s best interest to set the bar high and make sure that all involved understand that localization is not to be entered into lightly. Employee and employer are forced to make some tough decisions and to confront the questions of whether the long-term goal is localization or eventual return to the home country, and whether it will ultimately result in cost savings. But in the long run, the result is better for both the employee and the employer when the right decision is made at the outset.