Where a financial instrument involves a periodic adjustment for changes over time, an adjustment formula is built to fix the performance of the instrument to match. So, for example, inflation is a significant problem with a payment model that pays over time, such as 5, 10, or even 20 years. The value of the payment erodes and decreases as time passes because inflation makes it worth less. While inflation can’t be stopped, the payment tool can be adjusted to increase, providing the same value even well after the original start. This is oftentimes labeled a “cost of living” adjustment, or COLA.
How a COLA Gets Applied
Typically, a COLA starts to kick in a year or two after the original payment issuance begins. At first, the adjustment is very small, a fraction. However, as inflation continues, the adjustment starts to get larger, more noticeable. Each adjustment allows the payment approach to keep up with the impact of the relevant inflation rate, filling in the gap created by the value erosion.
In most cases, a COLA is connected to or based on a specific index or metric. The consumer price index for a given economic sector, or CPI, is a regularly used benchmark. Based on the percentage of the CPI change from year to year, a COLA amount is calculated similarly for a related adjustment increase. CPIs work extremely well for COLAs because they are widely accepted in different industries as the accepted rate of cost changes. They are rarely changed, and CPIs are often used universally within the country or region they apply to. CPIs don’t undergo significant changes either. They tend to stay in a single-digit range which, above 5 percent, is already a significant adjustment for the overall payment value.
Other Application Scenarios
COLAs are used in settlements that pay out to the recipient over a long period of time, for social security, for pensions and retirement plans, for annuities, and other mechanisms that provide a recipient value year after year. While a CPI, as mentioned above, tends to be a standard, it’s not a requirement. COLAs can be based on other formulas as well. As long as the parties involved agree to the mechanism, the COLA becomes applicable. That said, it’s fairly uncommon to use a private COLA formula.
COLAs Help But Aren’t a Complete Protection
Retirement plan cost-of-living adjustments are a positive feature to have in a plan, especially once a person is on a fixed income schedule. That said, they barely keep up with the totality of changes that usually occur with time. One has to take into account that more than inflation is usually at work. In addition to the erosion of value, there are also taxes on retirement funds, especially where the funds are pre-tax and still have yet to be reduced because of income taxes owed. The combination of both a COLA as well as withdrawing funds when one’s tax bracket is much lower than during earning periods is essential to hold onto as much value as possible.
Rates of Change Fluctuate
While big organizations may have a COLA of 1 to 3 percent annually, other factors can come into play. Where an organization has collective bargaining, for example, the negotiations may include an agreement for a larger COLA amount over the time period of a labor contract. That could get into the higher ranges of adjustment, as much as 5 percent annually. Normally, COLAs don’t move higher than that figure, as inflation has been historically low. However, in 2022 and 2023 inflation has exceeded these low figures, so it is likely that COLAs based on CPI will probably be calculated higher, as much as 8 to 10 percent, depending on the circumstances.
A Plan is as Good as Its Management
Utilizing a plan administrator who understands the technical mechanics of applying a COLA is key. This provides consistency in account management that provides stability and predictability from year to year, the cornerstone of retirement account management success.
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