What Is a Cost of Living Adjustment?

What Is a Cost of Living Adjustment? article image.

A cost of living adjustment (COLA) is an increase in your pay or benefits that often depends on the rising cost of goods and services—also called inflation. Adjustments may be especially important for retirees and people with disabilities, who may have a fixed monthly income, as rising prices for medical care, food and other everyday necessities can have a big impact on their budget.

What Is the Purpose of a Cost of Living Adjustment?

Broadly speaking, cost of living adjustments provide a way to at least partially offset inflation. As the cost of goods and services increases, employees and retirees need to earn more money to afford the same lifestyle.

These adjustments may be most common for federal employees and benefits recipients, as laws and contracts may dictate how and when the COLAs apply. For example, most public local, state and federal pension plans have automatic COLAs—although the details can vary depending on the plan. Private pensions, on the other hand, often don't offer a COLA.

For people who are working, employers may give an annual or occasional COLA. The amount could be in addition to a raise and not based on performance—the adjustment is meant to help the employee maintain rather than increase their purchasing power.

As with pension benefits, wage COLAs may be most common with public sector jobs. However, adjustments are sometimes negotiated as part of union contracts with both public and private employers.

Another type of adjustment depends on local economies. For example, military members may get a cost of living "allowance"—still called a COLA—based on where they're stationed. And some private employers may adjust salaries based on where an employee lives.

Regional pay differences can depend on additional factors, though, such as local labor markets, along with changes in the cost of living. The increased opportunity to work remotely also has some employers rethinking how and if they'll make adjustments based on where employees live.

How Does the Cost of Living Adjustment Work?

Cost of living adjustment calculations can work differently depending on the organization paying the benefits or wages. The Social Security COLA is perhaps the most widely discussed regular adjustment because so many people receive Social Security benefits—about 65 million in June 2021, according to the Social Security Administration.

Social Security Cost of Living Adjustments

The requirement and formula for the Social Security and Supplemental Security Income (SSI) benefits COLA is part of the Social Security Act. Starting in 1975, inflation rates have determined the potential changes in monthly benefits.

Today, Social Security COLAs are based on the third-quarter averages of the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) for the previous and current year. Benefits increase in line with the CPI-W increase, if there is one, and the amount is announced near the end of the year. The increase takes effect starting in January of the next year.

Since 1975, the Social Security COLA has led to an increase in benefits every year except 2009, 2010 and 2015. For 2021, the COLA adjustment was 5.9%. As a result, the average Social Security benefit for retired workers will be $1,658 in January 2022, a $93 increase from the previous monthly benefit.

Other Cost of Living Adjustments

The COLA for other types of benefits, pensions and wages may depend on different calculations and timelines. For example, many agencies and organizations use the more general Consumer Price Index (CPI or CPI-U), rather than the CPI-W, to determine potential COLA amounts. And some may use a local rather than national CPI.

Additionally, your specific COLA could depend on the contract you have with an employer. In some cases, you might not receive a COLA until after you meet a certain retirement age—even if you started collecting benefits before that point.

There could also be minimum and maximum COLA amounts regardless of CPI changes. For instance, a pension might guarantee a COLA of at least 1% or 2% per year, even if the inflation rate is lower. But when inflation is higher than that point, the COLA may only be a percentage of the CPI increase, up to a certain point.

If you're interested in understanding how a COLA could impact your wages or benefits, review your contract or contact your employer, human resources department or union representative.

Understand How Inflation Impacts Your Finances

If you're not receiving a cost of living adjustment, rising prices might mean you have to find ways to make more money or cut expenses. Depending on your financial situation, you may want to look for ways to invest when inflation is high. Or, at least, figure out how to survive inflationary periods.

Neither inflation nor your income directly impacts your credit reports or scores. However, there can be indirect effects, especially if a constrained income makes it hard for you to afford your monthly bills. You can always get a free copy of your Experian credit report and FICO® Score based on the report to check where you're at today.


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