How Is My Salary Affected by a Cost of Living Adjustment (COLA)?

Susan Kelly

Jan 13, 2024

An increasing number of companies are include inflation-related pay modifications in their compensation plans. Social Security and State Assistance can also be referred to as CPI-W adjustments, which are typically based on the annual percentage increase in the Consumer price for a given period of time.

A cost-of-living adjustment, or COLA, may be included in the contract of workers who are members of a union. For example, the COLA is a good example of this in the postal service. Cost-of-living adjustments, on the other hand, are left up to the employer's discretion for the most part.

How to Calculate a Cost-of-Living Increase in a Salary

To maintain a reasonable quality of living, one must spend money on necessities such as housing, food, clothes, utilities, taxes, and medical care. How effectively your salary can sustain you and your family is affected by changes in the price of these essentials, whether they go up or down.

Cost-of-living adjustments are calculated differently by each company. The Consumer Price Index (CPI) is not an official measure of the cost of living, although some employers may use the CPI increase of the previous year as an indicator (CPI). This is done by measuring changes in a basket of household goods and services over time using the Consumer Price Index (CPI).

The CPI's methodology has evolved throughout time, and there is considerable controversy as to whether or not it is a trustworthy predictor of real inflation expectations. However, the formal BLS website notes that the CPI is not supposed to be an expense index, even if businesses may use it to compute COLAs.

Cost of Living Indices is also provided by respected organizations like the Council for Community and Economic Research (CCER). Firms commonly use COLAs to entice and retain high-quality employees. Inflation-adjusted salaries may put a firm at a competitive disadvantage compared to organizations that provide this benefit to employees. Employers may give a non-inflationary cost-of-living adjustment to persuade workers to accept job moves.

Relocation Adjustments in Cost of Living

When a person relocates to a new city while still working for the same employer, they may earn a raise to compensate for the greater cost of living. Employees in New York City, where services and goods are more costly, may obtain a raise because they relocate from Chicago, where the cost of living is lower.

If you're considering accepting a new job in a different location, a city's cost of the living index might help you gauge whether or not the compensation offered is in line with your present earnings and way of life. Different states and areas have different taxes, food prices and housing costs. With a reduced cost of living comes a greater return on your investment. The greater the cost of living, the less money people have left over after paying for the necessities and the higher their wages must be to maintain the same standard of life as someone in a lower-cost location.

COLA and Income for Retiring People

Pension and investment income for retirees on a fixed income can be substantially eroded over time by inflation and rising costs for goods and services. Early retirees may find themselves squeezing pennies in the future if their monthly income remains flat while their essential expenses—food, shelter, health care, and taxes—increase. Inflation has reduced their purchasing power, causing them to be unable to afford necessities.

A COLA can raise a retiree's fixed retirement income to keep pace with inflation in some instances. For as far as the COLA calculation is significant enough, inflation-indexed pensions and federal subsidies like Social Security will keep their purchasing power when retired income increases based on the COLA formula.

Pensions Have an Annual Benefit Cap

Each year, the Internal Revenue Service (IRS) revises the optimal advantage that pension plan members can receive. In 2020 and 2021, the yearly benefit for a defined-benefit plan or retirement cannot exceed $230,000. Additionally, the yearly benefit must be lower than 100% of the participant's greatest three consecutive calendar years' average salary. For 2020 and 2021, the full benefit amount increased by $5,000 from the previous year's maximum benefit of $225,000 per year.

The Bottom Line

The word "cost of living" refers to the amount of money it takes to maintain a certain standard of living. Cost of living indexes can be used to compare earnings. A cost-of-living adjustment formula can be used to alter the basic living costs of some forms of income, such as pensions, contracts, and government benefits. Your salary's cost-of-living adjustments are usually determined by your company.

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