The
rising costs of food, gas, electricity, and health care can strain anyone's
budget. The situation is even worse if your living expenses increase while your
income stays the same, because your purchasing power will steadily decline over
time. That's why cost-of-living adjustments, or COLAs, are especially valuable
to retirees and others living on fixed incomes.
How
COLAs work
A
COLA is an increase in regular income you receive (such as a Social Security or
pension benefit) that is meant to offset rising prices. It's important
protection because price inflation has occurred almost every year in the last
40 years.
Data Source: Bureau of Labor Statistics
It's
easy to think of a COLA as a "raise," but a COLA is meant to help you
maintain your standard of living, not improve it. For example, let's say you
receive a $2,000 monthly retirement benefit, and the overall cost of the things
you need to purchase increases by 3% during the year. The next year, you
receive a 3% COLA, or an extra $60 a month, to help you manage rising prices.
That
3% COLA doesn't sound like much, but without a COLA, inflation can seriously
erode your retirement income. Assuming a 3% inflation rate, in just 10 years,
the purchasing power of your $2,000 benefit would drop to $1,520, and in 25
years, the purchasing power of your benefit would be only $963, less than half
of what you started with.
Who
receives COLAs?
Social
Security is the major source (and in some cases the only source) of
inflation-protected retirement income for many Americans. Social Security COLAs
are announced each October, based on increases in the average Consumer Price
Index for Urban Wage Earners and Clerical Workers (CPI-W) from the third
quarter of the last year a COLA was payable to the third quarter of the current
year. For example, because the CPI-W rose 1.7% between August 2011 and August
2012, Social Security and SSI beneficiaries received a 1.7% COLA, beginning
with December 2012 benefits. However, if there is no rise in the CPI-W, then
beneficiaries will not receive a COLA.
COLAs
are also commonly paid to retirees who are covered by state or federal
pensions. However, most private pensions do not offer COLAs.
Less
commonly, employers offer COLA increases as part of compensation packages. You
may also purchase riders to certain insurance policies (such as disability
income and long-term care policies) that ensure that benefits you receive keep
pace with inflation.
Should
you count on COLAs?
As
important as COLAs are, they are still vulnerable to cutbacks. For example,
pension plans that are underfunded may view reducing COLAs as a relatively
simple way to cut costs, and some plans have attempted to eliminate COLAs
altogether, although there have been legal challenges. Changing the COLA
formula that the Social Security Administration uses has also been proposed as
a way to save money and strengthen program reserves.
So
while you should appreciate the value of COLAs, you should also take other
measures to account for the effect of long-term inflation. These include using
realistic inflation and investment return assumptions when planning for
retirement, maintaining a diversified portfolio that reflects your time horizon
and tolerance for risk, and considering investments that have historically held
their own against inflation.
