What Is a Cost of Living Adjustment?

COLA Explained

man grocery shopping
••• Photo: Getty Images

A cost of living adjustment (COLA) 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.

Learn how cost of living adjustments are calculated, why they are implemented, and who benefits from them.

Definitions and Examples of the Cost of Living Increase

The cost for all goods and services, including vital ones such as food, shelter, and medical care, continues to rise. Earnings used to pay for the necessities of life need to also rise, otherwise many people could not afford the cost of living. Cost of living increases are designed to help keep the amount of money coming in stay in proportion to the amount of money going out. If things cost more, you need more money to pay for them.

For example, the government may provide a COLA each year on Social Security benefits. The Social Security Administration's (SSA's) COLA adjustment for 2020 was 1.6%; for 2021, it is 1.3%. This means that Social Security beneficiaries will receive a 1.3% increase in benefits in 2021 compared to the 1.6% increase in 2020.

The California Public Employees' Retirement System (CalPERS) is the pension system for retired public workers in the state. It also offers a COLA base on three factors: the Consumer Price Index (CPI), the employer-contracted COLA provision, and the year of retirement. In this system, the longer ago retirement was, the higher COLA a beneficiary will receive. This is because retirement earnings are based on how much someone was earning when they retired. Since wages continue to rise, someone who is more recently retired would earn a larger retirement benefit every month and not need as big of a COLA increase as someone who retired 10 or 20 years ago when wages were lower.

How Does the Cost of Living Increase Work?

The SSA bases its COLA increases on the CPI for Urban Wage Earners and Clerical Workers (CPI-W). The CPI-W is a version of the Consumer Price Index that looks at the average change over time in the prices paid by urban wage earners and clerical works for a market basket of consumer goods and services.

According to the U.S. Bureau of Labor Statistics (BLS), the demographic that the CPI-W encompasses is about 32% of the United States' population.

The Social Security Act sets the formula that is used to determine each COLA. If the BLS is trying to determine the COLA for January 2021, they need two pieces of information. They need the CPI-W from the average for the third quarter of 2020 and the CPI-W from the average for the third quarter of the last year in which COLA became effective. In this case, 2019 was the last year COLA was used.

They compare the two to see if there was an increase. If the CPI-W increased, that means prices have increased. If prices have increased, there will be a COLA adjustment. If prices stay flat, there won't be a COLA for that quarter. Additionally, it's rare to see COLA used when prices drop, a situation known as deflation

The base average CPI-W for the third quarter of 2019 was 250.200 and the average CPI-W for the third quarter of 2020 was 253.412. To arrive at the COLA amount for 2021:

(253.412 - 250.200) / 250.200 x 100 = 1.3%

The COLA for 2022 will be determined after numbers for the third quarter of 2021 are released.

A cost of living adjustment is used by both the government and companies. For the government, they use the adjustment with benefits for the people they serve, such as using COLA to adjust Social Security benefits. The government also uses COLA to adjust the pay of their employees. Both federal and state employers often increase wages according to the Consumer Price Index. For example, for the Federal Employees Retirement System (FERS) or FERS Special benefits, price increases are different for inflation below 2%, between 2% and 3%, and above 3%.

Companies may also use COLA to adjust employee wages, though it is not as common. In profit-driven and competitive environments, companies may give raises based on merit alone. Other companies may use COLA to adjust wages during booming economic times but may cut the adjustment out when economic times are bad. After all, companies, whether public or private, have to maintain a level of profitability.

Alternatives to COLA

Some have criticized how the cost of living adjustment is calculated. As we shared, the SSA bases its COLA increases on the CPI-W. That index is based on spending patterns of urban wage earners and clerical workers. The individuals that comprise the index are working and earning wages. They are not retirees.

It's reasonable to believe that spending patterns would be different for those who are working compared to those who are retired, especially when it comes to health care costs. So why base an increase in Social Security benefits on an index that tracks a demographic that isn't receiving Social Security benefits?

One solution that has been proposed is to base the COLA on an index that specifically tracks the expenses of the elderly; an index such as the CPI-E. The CPI-E tracks the expenses of Americans who are 62 years of age or older. While there has been a push to replace the use of the CPI-W with the CPI-E, it hasn't come to fruition yet.

The CPI-E is still considered an "experimental" price index, whereas the CPI-W is an "official" price index.

Notable Happenings

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 in 1971. 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%. It was 6.0% for a few years, then skyrocketed to 9.9% in 1979. It increased by 14.3% in 1980 and 11.2% in 1981. By that time, Federal Reserve Chairman Paul Volcker had raised the fed funds rate to 20%. That helped tame inflation but may have lead to unintended consequences, such as enabling, or contributing to, the recession that followed.

Since 1982, COLA has remained below 7.4% a year. 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% or less since 1992. The only exception was in 2009 when COLA rose 5.8%. That was rise was aided by spiking oil prices caused by commodities trading.

Key Takeaways

  • As the cost of goods and services continues to rise, the cost of living increase (COLA) was designed to allow retirement and social security earnings to keep up with the rate of inflation.
  • COLA relies on the Consumer Price Index as a way to determine how much increases should be.
  • Some advocates believe the COLA should more closely align with the cost of goods and services people over the age of 62 use.
  • With an aging population and an increasing number of Americans relying on Social Security benefits, the importance of accurately calculating the COLA grows in importance with each passing day.