Cost of Living Adjustment, How Its Calculated, and Its Importance
How COLA Protects You from Inflation
The cost of living adjustment is an increase in income that keeps up with the cost of living. It's often applied to wages, salaries, and benefits. These include union agreements, executive contracts, and retiree benefits. The government includes COLA for recipients of Social Security benefits. COLA helps retirees, who are on a fixed income, maintain a viable standard of living in the face of inflation.
Why don't businesses use COLA more often? They hire, give raises and fire based on merit. That's because they compete with each other to remain profitable. If workers contribute to that profitability, they are given raises, regardless of whether the cost of living has increased or not. If they don't contribute, they won't get raises, and they might even get fired. Companies might award COLA to their best employees when they ask them to move to a more expensive location.
The government uses COLA because it isn't in a competitive environment. Their salaries are lower than similar ones in the private sector. To get good employees, they must offer benefits like COLA.
How It's Calculated
COLA bases its increases on the Consumer Price Index. That's the federal government's official measurement of inflation. It measures changes in the prices of 80,000 goods and services. COLA is triggered when prices go up. It's rare to see COLA used when prices drop, a situation known as deflation.
Cost of Living Adjustment Calculator
The Social Security Administration tells you the latest COLA figures, so you don't need a calculator. Federal retirees can find the latest adjustments at COLA Adjustments for Civil Service Retirement Benefits. Retirees from the Armed Services can find their changes at Cost of Living Adjustments. If you want to do your calculations, use this CPI Inflation Calculator.
Congress added COLA to Social Security benefits in 1975. The country was facing double-digit inflation at the time. President Nixon had removed the U.S. dollar from the gold standard. That meant that the dollar was no longer redeemable for its value in gold. As a result, the value of the dollar plummeted. When the dollar's value drops, prices of imports rise. That contributes to inflation.
Before 1975, Congress had to vote for each change in Social Security benefits. COLA allowed benefits to increase automatically with rising prices. The adjustments occurred right in the nick of time. In 1975, COLA rose 8.0 percent. It was 6.0 percent for a few years, then skyrocketed 9.9 percent in 1979. It increased 14.3 percent in 1980 and 11.2 percent in 1981. By that time, Federal Reserve Chairman Paul Volcker had raised the fed funds rate to 20 percent. That tamed inflation but caused a recession.
Since then, COLA has remained below 6 percent. That's because double-digit inflation has been eliminated. Thanks to Volcker, businesses know they can only raise prices so far before the Federal Reserve will step in and raise interest rates. In fact, COLA has been at 4 percent or less since 1992. The only exception was in 2008 when COLA rose 5.8 percent. That was only because of spiking oil prices caused by commodities trading.
Why COLA Is Not as Important Anymore
COLA isn't critical when inflation is not a threat. We have the Federal Reserve to thank for taming inflation. The Fed has a 2 percent target inflation rate. When the core CPI rises above that, the Fed can enact contractionary monetary policy and slow down the economy. (The core CPI excludes volatile food, oil and gas prices.) By announcing its target, the Fed has removed the expectation of inflation. It's this expectation that costs will rise higher that makes businesses raise prices even faster, hoping to maintain profit margins.
Once the expectation is removed by Fed policy, then the threat of inflation is minimized.
There are three other reasons why inflation is no longer a threat. First, China and other exporters have a lower cost of living themselves. That allows them to pay their workers less. That keeps the prices of imports from their countries level. Also, China pegs the value of its currency to the dollar, further ensuring low prices.
Second, innovations in technology keep costs down. For example, high-tech manufacturing equipment lowers production costs. Also, new features from smartphones, tablets and flat-screen TVs keep prices very competitive.
Third, the 2008 financial crisis walloped economic growth, thereby reducing demand. Instead of raising prices, businesses dropped them. That cut costs but created high unemployment. For many people, wages are much lower than before the Great Recession, if they can get jobs at all.