Cost of Living Adjustment

By Sean Stevenson – Latest Revision February 15th, 2021

What Is The Cost Of Living Adjustment?

The cost of living adjustment (or COLA for short) represents a sponsored increase toward a fixed income that an individual receives, in order to keep up with inflation and modern costs of living. 

Commonly, the cost of living adjustment increase is made to supplemental security income and social security payments. 

However, there are various other ways in which the cost of living adjustment may be applied. 

Example

Wages, benefits, and salaries, may all receive a cost of living adjustment.  Depending on the circumstances, this ensures that they keep up with changes in the economy, and are not deterred by inflation rates.

A prime example of a cost of living adjustment can be seen in US government spending on social security benefits, where an increase of 1.6% occurred in 2020. 

Further examples of situations where a cost of living adjustment may be applied include:

  • Executive contracts.
  • Union agreements.
  • Group pensions.
  • Collective bargaining agreements.
  • Retiree benefits.

Key Takeaways

  • The cost of living adjustment is an increase in payments received.
  • It ensures that an income is not compromised over time by inflation rates or higher costs of living.
  • There are many instances where COLA might be applied. 
  • A common example of a cost of living adjustment is social security benefits, where adjustments will be made to account for economical and inflationary considerations.

Understanding The Cost of Living Adjustment

The essence of COLA is that it increases an amount of income received to reflect changes in the general economy.  As inflation and living expenses rise, the amount of money being received by an individual is diminished as a direct result. 

This is where the cost of living adjustment kicks in.  It helps to hedge supplemental income against economic forces. 

In essence, the cost of living adjustment serves as a percentile increase towards supplemental income.  It negates the impact of additional living costs and inflation.

Cost of Living Adjustment

As depicted in the image above, the rising percentile of inflation and associated costs of living are met with the cost of living adjustment as a financial counterweight.  This ensures that the recipients of benefits (such as social security) are still receiving an undiminished income.

This helps to preserve the weight of capital owed to an individual, allowing them to maintain their standard of living. 

The added security of knowing your income is secure and hedged against financially unfavorable circumstances is a huge benefit to recipients.

This is why COLA is so often prized.  It offers a unique financial benefit that has become increasingly rare and sought after in modern economies.

How Cost of Living Adjustments Are Calculated

The cost of living adjustment uses a specific formula for its calculation.

The cost of living adjustment is determined by the Bureau of Labor Statistics (or BLS), who then pass their findings onto the Social Security Administration (SSA).  The SSA calculates the COLA by applying the percentile increase in the consumer price index for urban wage earners.  This calculation uses data from the third quarter of one year to the exact same date of the following year -which determines the exact amount of compensation that will be dispensed. 

The SSA regularly post and update this information, ensuring it is made available to the public.

In this way, the COLA formulae is made to account for additional economic considerations for those receiving supplemental income. 

Economic Impact of COLA

Cost of living adjustments have safeguarded retirees and supplemental income sources for decades.

It was estimated in 2020 alone, that more than 63 million Americans saw a 1.6% increase in their supplemental security income and social security benefits.

Many fixed incomes rely on cost of living adjustments.  This allows them to maintain monetary commitments to their beneficiaries.  

To date it is estimate that more than 1 in every 6 U.S residents collected Social Security benefits within the last two years (1).  Older Americans are said to represent about 4 out of 5 beneficiaries.

Cost of Living Adjustment

To date, nearly one fifth of all social security beneficiaries are receiving disability or young survivors benefits.

Depicted above, is a breakdown of Social Security beneficiaries as of June 2020.  Based on this data alone, the importance of safeguarding fixed incomes through cost of living adjustments remains a social imperative.

COLA in the workplace

Government sectors tend to use cost of living adjustments because they operate in a non-competitive climate. 

Since the salaries offered by government employment tend to be lower than the private sector, they must offer COLA and other benefits.

Professionals actively seek to be employed in government because they want job security.  The added benefit of COLA-safeguarded benefits are a huge draw to many prospective job-seekers who wish to build a stable career.

Conversely, both businesses and the private sectors do not make use of COLA nearly as often as the government.  They instead must rely on the merit of their employees to remain solvent, or to achieve heightened prosperity.

Workers that prove themselves capable will be granted raises and promotions.  Those that fail to perform will likely be let go.

Many companies often provide cost of living adjustments to ideal employees, especially when they are relocated to a different location that might prove expensive.

History of Cost of Living Adjustments

In the 1970s, inflation had reached a heightened pitch in the economy.  Many business, employment, real-estate, and government contracts made use of COLAs to hedge themselves against rising inflationary rates.

By 1975 the United States congress voted to add cost of living adjustments to social security.  This was in the face of double-digit inflation within the economy.

Further adding to the controversy, was President Nixon, who had just finished removing the U.S dollar from the gold standard in 1971.  This created a financial vacuum, in which the US saw its own dollar value plummet.

Against the value of foreign currencies, the US found its own monetary policies lagging far behind.  The price of imports rose dramatically, further contributing over time to inflationary rates.

However, with the addition of cost of living adjustments made to social security benefits, adjustments began to kick in before the situation worsened any further.

In 1975 alone, cost of living adjustments rose 8%, with several more years following of rising inflationary periods.  This culminated in a staggering 14.3% rise in 1980, followed by another 11.2% rise in 1981.

In desperation, Federal Reserve Chairman Paul Volcker invoked a raise of 20%.  While Volcker’s goal to halt inflation may have been admirable at the time, it nonetheless resulted in a recession.

Despite the ensuing recession, double-digit inflation has effectively been eliminated since 1982.  In more recent years, it has even remained below 8%, with the only spike occurring during the 2008 financial crisis at a nominal 5.8% inflationary percentage.

Cost of Living Adjustment

Over several decades now, wages have failed to keep pace with inflation.  This is despite the fact that worker productivity has steadily increased.  As a result, there is some concern that homelessness may again rise substantially in HCOL (high cost of living) areas.

The Importance of Cost of Living Adjustments Today

As our economy has recovered from the financial crisis of 2008, we have entered into the longest-running bull market in history.

Despite this record growth, we are now facing a tell-tale sign of a shift in our business cycle.  This means that inflation may again become a problem.

In North-America, our governments target specific inflation rates using monetary policy and spreading economic awareness.  When the Fed announces that inflation is under control, businesses and individuals breathe a little easier, knowing that economic threats have been curtailed.

However, inflation must be constantly monitored and swift policy assigned to its suppression. 

Undoubtedly, the risk of inflationary influence taking hold again is a constant backlog that must be taken seriously by policy makers and institutions alike.

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