Some companies build salary adjustments into their compensation structures to offset the effects of inflation on their employees. Cost-of-living adjustments (COLAs) can also refer to annual adjustments made to Social Security and Supplemental Security Income, which are generally equal to the percentage increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) for a specific period.
Workers who belong to a union may have a cost-of-living adjustment, sometimes referred to as a cost-of-living allowance, built into their contract. One example is the COLA required for U.S. Postal Service workers. For most employees, though, cost-of-living adjustments are made at the discretion of their employer.
Key Takeaways
- A cost-of-living adjustment (COLA) is an increase in benefits or salaries to counteract inflation.
- Inflation for the Social Security COLA is calculated annually using the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).
- The cost of living will also vary city to city and state to state, with large urban centers often demanding a higher cost to live.
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How Salary Cost-of-Living Adjustments Are Calculated
Cost of living refers to the amount of money required to maintain a standard of living, accounting for basics like housing, food, clothing, utilities, taxes, and health care. Increases (or decreases) in the price of these necessities affect the cost of maintaining your lifestyle, and this, in turn, shapes how well your income will support you and your dependents.
The computation involved in cost-of-living adjustments can vary from employer to employer. There is no official cost-of-living metric, but some employers may use the prior year’s rise in the Consumer Price Index (CPI).
The Bureau of Labor Statistics (BLS) measures price inflation with the CPI, which measures temporal changes in a set basket of consumer goods and services. The methodology behind the CPI has changed over time, and there is some debate about whether it is a reliable indicator of real inflation levels. While CPI may be used by employers to calculate COLAs, the official BLS website points out that the CPI is not meant to be a cost-of-living index. The Council for Community and Economic Research also provides a reputable Cost of Living Index.
In general, employers use COLAs to attract and keep valuable employees. A company that does not offer salary adjustments to offset inflation might find itself at a competitive disadvantage to companies that do offer this type of benefit to employees.
There is another type of cost-of-living adjustment not directly tied to the rate of inflation, but employers may offer it to make employees more willing to accept job transfers.
Cost-of-Living Adjustments for Relocations
Sometimes an employee may transfer to a new city while maintaining the same job and receive a salary increase to offset the higher cost of living in the new location. An example is an employee who receives a salary increase because he is transferred from Chicago to New York City, where consumer goods and services are more expensive.
If you are considering moving to another city to accept a new job, cost-of-living indexes can be used as an indicator of how suitable a salary offer is relative to your current income and standard of living. Housing, food, and taxes vary among states and even regions. Cities, regions, and states with a lower cost of living usually mean your income will go further. Living in areas with a higher cost of living usually results in workers having less disposable income, or money in their bank accounts, after paying for the basics and needing higher incomes to live the same way they would in a less costly region.
Sometimes the term COLA is used to describe salary “adjustments” or allowances for workers, including military personnel, temporarily relocated to another city, region, or country. Though the idea is to compensate workers for a change in their welfare resulting from moving to a different location, the adjustment or bonus pay may be more accurately described as a per diem allowance to be used for a temporary and specific cost, such as a higher rent payment. The extra payment does not continue when the temporary assignment ends, whereas a true COLA for a permanent salary would remain in place.
COLA and Retirement Income
Over time, inflation and increasing prices for goods and services can seriously erode investment income and pension benefits for retirees living on a fixed income. If monthly income remains relatively the same while basic costs—food, shelter, healthcare, taxes—increase, retirees who enjoyed comfortable early retirements may find themselves pinching pennies as time goes on. This is because their purchasing power has been eaten away by inflation.
Some forms of retirement fixed income do increase with the cost of living, due to a COLA. Income derived from COLA-based pensions, COLA-indexed pensions, and government benefits for retirees-such as Social Security, will retain their purchasing power as inflation increases, as long as their COLA formula is sufficiently generous.
Annual Benefit Limit for Pensions
The IRS periodically updates the maximum benefit that participants can receive from a pension plan each year. The annual benefit for a defined benefit plan or pension must be less than $245,000 in 2022. Also, the annual benefit must be less than 100% of the participant’s average compensation for their highest three consecutive calendar years.
The maximum benefit amount for 2022 includes a cost-of-living adjustment or increase of $15,000 from 2021 and 2020, in which the maximum benefit was $230,000 per year.
The Bottom Line
The phrase “cost of living” refers to a measure of the cost of sustaining a certain standard of living. Cost-of-living indexes can be used to compare salaries across different areas. A cost-of-living adjustment calculation may be used to increase certain kinds of income, such as contracts, pensions, or government benefits, so they can keep up with increasing basic living costs, as represented by the CPI or cost-of-living indexes. In general, cost-of-living adjustments to your salary will be determined by your employer.