Cost Of Living Adjustment

Article byWallstreetmojo Team
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

What Is The Cost Of Living Adjustment? 

A cost of living adjustment refers to an adjustment needed to be made in an individual’s income to maintain a certain basic standard of living at a particular point in time. Pay adjustments can be made to a variety of revenue, including salaries, benefits, and more.

Cost of living adjustment

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Adjustment to the cost of living is essential as the cost of goods and services continues to rise. It is a matter of being able to afford the lifestyle an individual lived before the rise. The adjustment cost should enable individuals to continue a similar lifestyle despite increasing prices.

Key Takeaways

  • The Cost of Living Adjustment is annual changes in individual salaries or benefit payments due to an increase in the cost of living so that people can maintain the former standard of living.
  • The COLA’s objective is to keep benefits from Social Security and Supplemental Security Income (SSI) from reducing purchasing power due to inflation. The Consumer Price Index has been the basis for Social Security’s public benefits and increases.
  • A COLA is determined using the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) percentage growth from the previous year’s third quarter to the current year’s third quarter.

How Does Cost Of Living Adjustment (COLA) Work? 

Cost of Living adjustments provides a way to offset inflation to some extent. As inflation increases, the cost of goods and services increases, and people who earn and retire will need more money to afford the same lifestyle they were enjoying. Both companies and governments can increase the cost of living, but the government generally does it more. The Consumer Price Index has been the basis for Social Security’s general benefits increases. These increases are referred to as COLAs or Cost of Living Adjustments. 

Whether or not to grant a cost of living pay increase depends on the company’s or the government’s decisions. Using standardized inflation rates based on regional or national data, one can calculate it. Utilizing the Consumer Price Index is one method of calculating the cost of living rise. However, it’s crucial to remember that because of the constant increase in inflation, the cost of living will change yearly.

According to the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), a COLA is calculated by the percentage growth from the previous year’s third quarter to the current year’s third quarter. Therefore, COLA cannot exist without a change in economic growth. The Bureau of Labor Statistics, a part of the Department of Labor, calculates the CPI-W. Therefore, the Social Security Administration must utilize it as the official measure while determining COLAs.

The Consumer Price Index measures inflation. Data shows that inflation jumped 9.1% in June compared to the previous year (as per the 2022 report), the highest annual increase since November 1981. The situation is alarming as the inflation rate has hit a 40-year high. When prices rise, it brings instability with it. Higher prices can affect the standard of living. The problem becomes blatantly evident when the inflation rate outstrips pay growth. People’s wages do not increase while oil, food, and other necessities increase. To sustain them, one can receive better pay or cut expenses, and COLA helps ease the situation.

How To Calculate?

It is possible to calculate average cost of living adjustment by applying a formula in which we consider the percentage increase in the value of consumer price index by comparing it on a year on year basis.

The formula of the same would be as follows:
COLA = [(CPI in current period/CPI in previous period) -1] x 100

For the above calculation we need to follow some important steps, as elaborated below.

  • The first step in to gather all data related to the consumer price index of the years that are to be considered for calculation, which will ideally be that of the current year and the previous year.
  • Then we need to find the difference between the two CPI. We deduct the value of the index related to the previous year from the current year to observe the difference.
  • The next step is to divide the value obtained from the previous step by the index of the previous year.
  • The final step is to find the percentage change. For that we subtract 1 from the difference and then multiply it by 100 to get the final result. The above formula helps in offsetting the inflation effect and maintains the purchasing power of income of consumers.

The average cost of living adjustment is quite a simple process that can be calculated and interpreted easily.

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Examples 

Check out these examples to get a better idea of the cost of living adjustments:

Example #1

Ben works for a company in New York. In the past year, the cost of living in the city rose by 5% (COLA). Due to this, his employer decided to give the employees a 5% increment while Ben earned a salary of $ 10,000. Now let us calculate Ben’s cost of living adjustment salary:

Increment = $10000*0.05=$500 

This gives 10500 ($10000+$500), which is his cost of living adjustment salary. As a result, Ben requires a new salary of $10,500 to sustain a 5% increase in the cost of living. Here, the employee can afford the same lifestyle as before since there was an equal increment, similar to the rising cost of living. Again, the cost of living adjustment calculators available online can help for easy calculation.

Example #2

Venezuela, a South American country, has undergone a period of hyperinflation. It is a situation where monthly inflation rates rise above 50%. According to the BTI Transformation Index, inflation in that country reached an absurd 65,000% in 2018. As a result, the situation worsened, and people there could not afford funerals for their family members.

People unable to bear expenses are looking to get extra jobs to make ends meet. They are also trying to migrate outside the country in search of jobs and opportunities, as living inside the government has made it expensive and unaffordable. From this example, we can understand the gravity of the situation. With rising prices (to an excessive amount), no jobs or income security are available.

People with jobs cannot make ends meet and therefore work extra jobs to afford the same lifestyle or maintain their livelihood. Had their jobs appropriately apportioned cost adjustment amount, they would have had some relief. The elderly especially could use some help from the cost of living adjustment for social security.

The above examples clearly demonstrate the procedure to calculate the value of the COLA. We also understand the importance of the idea and how it helps the citizens of an economy if implemented properly.

Importance 

Let us go through the importance of the concept.

  • The COLA’s goal is to prevent inflation from eroding the purchasing power of Social Security and Supplemental Security Income (SSI) benefits.
  • It is essential as it helps people keep their purchasing power intact. The change in purchasing power due to inflation affect the salaries, wages of employees, and pension and other benefits reduce in value.  
  • It also helps in maintaining the financial health of a pension.
  • Moreover, COLAs can help people achieve their aims and financial goals even when high prices prevail.
  • Therefore, the cost of living adjustment for social security is significant for their retirement period.
  • Due to all the above, the employees remain satisfied because their compensation gets adjusted based on the changes in the cost of living. This not only gives them the value for money but also helps companies retain useful and valuable talent within the organization since the employees are satisfied with what they get.
  • From the above point it is also clear that the companies can reduce their cost of repeatedly hiring new employees and training them for job purpose,
  • Since the cost of living is considered as per the location and region, this concept ensures that people from different places and time zones have an equal income distribution, depending on the place where they live.
  • Since the effect of inflation on household income and budgeting is limited and controlled, the consumers gain confidence in the economy, and there is economic stability and peace.
  • A prominent importance of the concept is that it helps households and corporates to plan their finances and make budgets for the upcoming years with the expectation to achieve it within the required time period.

Thus, this concept is a good way to reduce the negative impact of inflation on finances and any form of financial benefits within an economy and maintain financial stability.

Frequently Asked Questions (FAQs)

1. How to ask for a cost of living adjustment?

Negotiating the cost of living is similar to pitching any other type of proposal. It starts with establishing oneself as a valuable asset to the company and doing the homework- one can use the cost of living adjustment calculator and keep it, choose the correct time, and ask confidently.

2. How to calculate the cost of living adjustment?

An example to demonstrate the same: suppose the base average CPI-W for the third quarter of 2022 is 200, and the average CPI-W for the third quarter of 2022 is 250. COLA can be calculated as 250-200/200*100=25% is the cost of living adjustment 2022. 

3. When are social security cost of living adjustments made?

The Consumer Price Index, which measures the cost of living, determines Social Security’s general benefit increases. These increases are referred to as COLAs or Cost-of-Living Adjustments. As of October 13, 2021, COLA is 5.9 percent, and the cost of living adjustment 2022 will be realized in October.

This article has been a guide to what is Cost Of Living Adjustment (COLA). We explain how to calculate it with the help of examples and also it importance. Here, we explain its working, importance, and examples to demonstrate the topic. You can learn more about it from the following articles –

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