Cost of Living Adjustment, How Its Calculated, and Its Importance
How COLA Protects You from Inflation
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 is 1.6%; for 2021, it is 1.3%.
Companies don't use COLA as much as the government. They hire, give raises, and fire based on merit, not a rising cost of living. They must do so 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
The SSA bases its COLA increases on the Consumer Price Index for Urban Wage Earners and Clerical Workers. COLA is triggered when prices go up. It's rare to see COLA used when prices drop, a situation known as deflation.
How COLA Affects the Economy and You
In 2020, more than 63 million Americans are seeing a 1.6 percent 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.
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 percent. It was 6.0 percent for a few years, then skyrocketed 9.9 percent in 1979. It increased by 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 1982, COLA has remained below 7.4 percent 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 percent or less since 1992. The only exception was in 2008, when COLA rose 5.8 percent. That was because of spiking oil prices caused by commodities trading.
Why COLA Has Become More Important
The 2018 adjustment was the biggest increase since 2011. The economy had finally recovered from the 2008 financial crisis. Strong growth had allowed businesses to raise prices.
COLA wasn't as important during the recession because inflation was 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. 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. 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.
Social Security Administration. "Cost-of-Living Adjustment (COLA) Information for 2021." Accessed Oct. 17, 2020.
Social Security Administration. "Latest Cost-of-Living Adjustment." Accessed Oct. 17, 2020.
Social Security Administration. "Cost-of-Living Adjustment (COLA) Information." Accessed Oct. 17, 2020.
Federal Reserve History. "Nixon Ends Convertibility of US Dollars to Gold and Announces Wage/Price Controls." Accessed Oct. 17, 2020.
Federal Reserve History. "Volcker's Announcement of Anti-Inflation Measures." Accessed Oct. 17, 2020.
Social Security Administration. "Cost-of-Living Adjustments." Accessed Oct. 17, 2020.
The Federal Reserve. "What Is Inflation and How Does the Federal Reserve Evaluate Changes in the Rate of Inflation?" Accessed Oct. 17, 2020.
World Data. "Comparison of Worldwide Cost of Living." Accessed Oct. 17, 2020.
Congressional Research Service. "China's Currency Policy." Accessed Oct. 17, 2020.