Cost-of-Living Adjustment

What It Means

The term cost of living refers to how much money is required to maintain a certain basic level of material comfort from one year to the next. In the United States the Cost-of-Living Adjustment (COLA) is an annual adjustment of wage contracts, retirement benefits, and other payments; it is intended to offset increases in the cost of living.

One of the main figures used to formulate the COLA is the Consumer Price Index (CPI), an index compiled by the Bureau of Labor Statistics (a division of the U.S. Department of Labor) that tracks the changing price of basic goods and services (such as milk, gasoline, bus fare, and electricity) in the United States. Change in the CPI is a measure of inflation, the general increase in the prices of goods and services in the economy.

COLAs are applied to government-assistance benefits such as Social Security (which provides retirement, disability, and survivors’ benefits to workers and their families and administers the Supplemental Security Income program for elderly, blind, and disabled persons with little or no income); federal-employee pension benefits; and military pension benefits. In general, the purpose of the COLA is to protect those people living on a fixed income from having the value of their income eroded by inflation over time. COLAs have also been used by labor unions as an important bargaining tool in negotiations of employee wages and pension plans. In many cases the term cost-of-living adjustment is used informally to mean a negotiated annual salary increase that is not tied to the CPI or other official indexes.

When Did It Begin

The Consumer Price Index was first instituted during World War I (1914–18), a period of rapidly increasing prices, as a way to calculate appropriate wage increases. Social Security retirement benefits were established in 1935. In the decades that followed, Congress periodically passed increases in Social Security benefits to compensate for gradual inflation, as measured by the CPI.

In the late 1960s and early 1970s, however, a considerable jump in inflation rates threatened to erode the real purchasing power of Social Security benefits and other fixed payments. During this period Congress approved four Cost-of-Living Adjustments in five years. Passed in 1972, the fourth of these increases included a provision that permanently calibrated COLAs to the CPI, making such adjustments an annual certainty for recipients of Social Security benefits. Automatic COLAs, no longer contingent upon Congressional approval, went into effect in 1975.

More Detailed Information

The rate of inflation is represented as a percentage increase. If annual inflation is estimated at 4 percent, for example, this would suggest that the price of a bus ride would increase from $1.00 to $1.04 over the course of a year. The COLA, which is also represented as a percentage increase, is usually about equal to the rate of inflation. For instance, the U.S. inflation rate for 2006 was estimated at 3.23 percent, and the COLA for that year was calculated at 3.3 percent. Suppose a retiree received a monthly Social Security benefit check of $1,011 throughout 2006; beginning in January 2007 that person would receive a monthly benefit check of $1,044 (an increase of $33, or 3.3 percent of $1,011).

COLAs are also applied to other kinds of payments. For example, the U.S. Department of Agriculture (USDA) applies COLAs to food stamp allotments (food stamps are coupons that can be exchanged for groceries; the USDA distributes them to low-income households). The agency also makes cost-of-living adjustments to its standards of eligibility for the Food Stamp Program. For example, whereas a few years ago a person with a monthly income of $750 might have earned too much to qualify for food stamps, inflation means that $750 buys less than it used to (that is, the cost of living is higher). Therefore, in order to deliver the Food Stamp Program to the neediest population of Americans, the USDA must increase its maximum income level for eligibility.

The idea of a cost-of-living adjustment is that payments should be calibrated and recalibrated according to how much money the recipient needs to maintain a basic level of health and comfort. Thus, such adjustments are sometimes implemented to offset regional differences in the cost of living. For instance, the cost of renting a two-bedroom apartment in San Francisco, California, is significantly higher than it is in Vicksburg, Mississippi. For this reason, COLAs may be appropriate in cases where an employee relocates from a relatively inexpensive area of the country to a relatively expensive one. In addition to the national CPI, the Bureau of Labor Statistics also compiles region-specific CPIs and CPIs that correspond to 27 different metropolitan areas around the United States.

For servicemen and servicewomen who are stationed in certain areas of the country that are categorized as “high cost” (there were 63 such areas as of 2007), the U.S. military compensates for the increased cost of living. It pays what is called a CONUS (Continental United States) COLA; in this case the abbreviation stands for “cost-of-living allowance,” because the adjustment is a stipend, or temporary extra payment, rather than a salary increase. These COLAs are calculated by the military, and they vary according to where the servicemember is stationed, whether he or she has any dependents (a spouse, children, elderly parent, or other person for whom the servicemember is financially responsible), and what his or her pay grade is. The standard, CPI-based COLA is also applied to military retirement benefits.

Recent Trends

In 2006 many senior citizens were worried that the Social Security COLA was not keeping pace with their needs, such that the real value of their Social Security benefits was dwindling. They argued that, while the COLA averaged slightly less than 2.6 percent from 2001 to 2006, the costs of home-energy bills, health care, and other expenses were growing at a much higher rate. Indeed, even though the COLA for 2007 was 3.3 percent, much of that was absorbed by the 5.6 percent increase in the amount that seniors had to pay for Medicare (a national health-insurance program for Americans age 65 and older). These critics of the Social Security COLA maintained that the CPI (which was used to determine the COLA) was based on goods and services purchased by young, urban workers and did not accurately reflect the most important expenditures of seniors, such as medications, doctor visits, and other kinds of health care.

Seniors and senior-advocacy groups decried the unfairness, inaccuracy, and inadequacy of this methodology and began to call for the Social Security COLA to be calculated according to the CPI-E, or Consumer Price Index for Elderly Consumers. The CPI-E already existed; it had been compiled and calculated by the Bureau of Labor Statistics for many years. The number of seniors in the United States was rising and constituted a powerful voting block, one that hoped to exert its political influence to change the way the Social Security COLA was calculated.