When inflation rises, paychecks don’t go as far as they once did. Employees may become stressed as they struggle to pay for essential goods and services, potentially hurting their productivity on the job. They might even leave the organization if someone is willing to pay them more for the same work. Employers who are looking to retain talent during tough economic times or relocate people from different geographic locations may need to consider cost of living adjustments (COLA).
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What is a cost of living adjustment?
A cost of living adjustment is an increase in pay or benefits to cover the rising cost of goods and services due to inflation. Recipients of a COLA may be employees in the private and public sectors or retirees on a fixed income. The latter is one of the most common examples of COLA. Since 1975, Social Security benefits have automatically increased annually, though there were a few exceptions in years when inflation was low.
How does a cost of living adjustment work?
Cost of living adjustments are generally proportionate to the consumer price index (CPI), which is a measurement of inflation. The Bureau of Labor Statistics compiles two types of CPIs:
- All Urban Consumers (CPI-U), covering approximately 93% of the U.S. population
- Urban Wage Earners and Clerical Workers (CPI-W), covering 29% of the population
As such, the amount an individual can expect in COLA depends on which CPI the government or the employer uses in the calculation. Contracts between employers and employees may also dictate cost of living adjustments.
Social Security cost of living adjustments
The federal government uses the CPI-W to determine cost of living adjustments for people receiving Social Security retirement benefits. It compares the previous year’s third quarter CPI-W to the current year’s third quarter CPI-W. The percent increase is announced towards the end of the year and takes effect on January 1.
Other cost of living adjustments
Cost of living adjustments are not limited to the Social Security Administration (SSA). Private and public sector employers might offer COLA for any of the following:
- Pensions
Whether pension benefits adjust for inflation generally depends on contractual agreements. The retired employee might have to be a certain age to receive COLA or there may be minimum and maximum adjustments. - Across-the-board raises
Employers sometimes offer cost of living adjustments to all employees to improve engagement and retention when inflation is high. - Relocation
An employee who transfers from a location with a low cost of living to one with a high cost of living may find that they have less disposable income. To incentivize this individual, the employer might use a COLA to cover the cost difference between the two locations.
In each of these cases, employers generally determine COLA using the CPI-U rather than the CPI-W. They might also use a local CPI.
How to calculate cost of living adjustments
Though many employers rely on the CPI-U, there isn’t a standard calculation that all businesses use to determine cost of living adjustments. The SSA, on the other hand, does have an official COLA method, which is as follows:
- Average the CPI-W across each month of the current year’s third quarter
- Average the CPI-W across each month of the previous year’s third quarter
- Calculate the percent difference between the two averages
- Round the result to the nearest one-tenth of one percent
Cost of living adjustment formula: (Current Q3 Average CPI-W – Previous Q3 Average CPI-W) / Previous Q3 Average CPI-W x 100 = COLA
Once COLA is determined, Social Security benefit recipients can calculate their increase for the upcoming year. For example, a retiree receives $1,200 per month in benefits and the Social Security COLA for the upcoming year is 8.7%. That person’s new monthly payment adjusted for inflation would be:
$1,200 x 1.087 = $1,304.40
Why is cost of living adjustment important?
Purchasing power decreases as inflation or cost of living increases. This inverse relationship mimics a pay cut for many employees and may harm their financial health. Morale and productivity may diminish as a result and workers might look for higher-paying opportunities elsewhere.
Cost of living adjustments can help prevent such unintended consequences of inflation. By offering raises consistent with the CPI, employers may be able to retain valued employees and keep them engaged.
Understand how cost of living impacts businesses
Employers must weigh the pros and cons of cost of living adjustments. While COLA can improve retention rates, high-performing employees who want to be rewarded based on merit may resent across-the-board raises.
In addition, cost of living adjustments can be expensive. When employees relocate, employers must not only account for the CPI and the cost of living difference between two locations, but also family size and housing costs. Some employees may even ask their employer to provide tax assistance or cover job-finding fees for spouses.
Frequently asked questions about cost of living adjustment
Do employers have to give cost of living adjustments?
Employers generally do not have to adjust wages or benefits for inflation unless they contractually agree to do so. Some voluntarily offer COLA during periods of high inflation to show they care about their employees, potentially improving engagement and retention.
Does everyone on Social Security receive the COLA increase?
If the federal government decides that a COLA is necessary based on the CPI-W, it applies to all Social Security recipients. COLA may not always be granted if the CPI-W does not increase.
What is a normal cost-of-living adjustment?
A cost of living adjustment might be considered normal if it directly correlates to the consumer price index, which measures inflation. Employers generally use the CPI-U or a local CPI in their COLA calculations, whereas the Social Security Administration always relies on the CPI-W.
This guide is intended to be used as a starting point in analyzing how to calculate cost of living increase for employees and is not a comprehensive resource of requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.
