Cost of Living Adjustment: How It's Calculated and Its Importance

How COLA Protects You From Inflation

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The 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.

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 2020.

How COLA Is Calculated

The SSA bases its COLA increases on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The CPI-W is a version of the Consumer Price Index (CPI) 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 states 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 average CPI-W for the third quarter of 2019 was 250.200 and the average CPI-W for the fourth quarter of 2020 was 253.412. When you calculate the percentage increase from 2019 to 2020, you arrive at 1.3%

Criticism of This Method

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.

A Brief History of COLA

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.

Who Uses the Adjustment?

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.

How COLA Affects the Economy and You

Any healthy economy can expect a little inflation. As long as citizens' income keeps up with the pace of inflation, there will be no issues when it comes to purchasing power.

If income grows at a slower pace than inflation, an economy may start to see a negative impact.

For retirees, the issue of inflation is especially pressing. Retirees are no longer working and rely on Social Security to maintain their standard of living. Imagine that a retiree receives $1,500 in benefits each month and has monthly expenses of $1,500. Now imagine that the economy experienced inflation of 5%. Now this retiree's expenses are $1,575. Without an adjustment to this retiree's income, they would be short $75 and unable to fully cover their monthly expenses.

This is where COLA comes into play. In 2021, more than 64 million Americans are seeing a 1.3% increase in their Social Security and Supplemental Security Income benefits. COLA helps these retirees, who are on a fixed income, maintain a viable standard of living in the face of inflation. Without an adjustment, those individuals depending on Social Security would undergo financial strain. The rippling effect of 64 million citizens under financial strain would be felt throughout the entire U.S. economy.

The Evolving Importance of COLA

The 2018 adjustment was the biggest increase since 2011. The economy had finally recovered from the 2008 financial crisis and strong growth had allowed businesses to raise prices.

The Fed has a 2% 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 removed the expectation of inflation. When companies expect costs to increase, they raise prices even faster, hoping to maintain profit margins. Once Fed policy announcements remove this expectation, it minimizes the threat of inflation.

There are three other reasons why inflation is not a huge threat:

  • First, China and other exporters have a lower cost of living themselves. That allows them to pay their workers less, which 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. 

The paragraphs above help explain why inflation has remained a low threat. Still, there are those who doubt the accuracy of the CPI and the use of the CPI-W for the cost of living adjustment. 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.