The rate at which the cost of goods and services increases over time is known as inflation. If someone’s income doesn’t increase by at least as much as the rate of inflation, he or she will experience a decrease in purchasing power. Retirees and others on fixed incomes are particularly susceptible to inflationary pressures.
In response to rampant inflation in the early 1970s, the federal government changed the way it calculates increases to Social Security benefits. It used to be that Congress would periodically adjust Social Security benefits to account for inflation. But beginning in 1975, the Social Security Administration (SSA) began using an annual Cost of Living Adjustment (COLA) to calculate changes, if any, to Social Security general benefits and Supplemental Security Income (SSI) benefits.
How is COLA determined?
The COLA is derived from the U.S. Bureau of Labor Statistics’ Consumer Price Index (CPI) program, which produces monthly data on changes in the prices paid by consumers for a predetermined “basket” of goods and services purchased by households, such as transportation, housing, food and medical care.
One of the variations of the CPI, the CPI-W, measures changes for urban wage earners and clerical workers. This is the formula used by the Social Security Administration to set its COLA – generally by applying the percentage increase in the CPI-W from the third quarter of one year to the third quarter of the next.
Any COLA changes to Social Security general benefits take effect with December payments and remain in place for the following 12 months. COLA changes for SSI benefits generally use the same percentage, although they usually become effective the following month.
If there is no increase in the CPI-W from third quarter to third quarter, then there is no COLA for that year. This is what happened in December 2009 when, for the first time since COLA was implemented, the CPI-W actually declined – which means that according to that measurement, the rate of inflation decreased in 2009.
The COLA for benefits for the 12 months beginning in December 2010 will be based on changes to the third-quarter averages from 2009 to 2010. To view a chart of Social Security Cost of Living Adjustments since 1975, click HERE.
Other types of COLAs
Other types of wages or benefits, such as those outlined in union contracts or pension plans, sometimes apply cost of living adjustments to keep pace with inflation, although they may use other variations of the CPI or some other formula. In the case of pensions, the COLA usually begins when the person begins drawing pension benefits.
In another variation on the COLA, some employers, including the U.S. military, sometimes provide a temporary cost of living allowance to employees who are asked or required to take assignments in cities or areas of the world with a far higher cost of living than where they currently live. Typically these supplements expire when the assignment is completed since they aren’t considered a raise.
And, the IRS makes annual adjustments to employee and employer contributions to pension plans, IRAs, 401(k) plans and other income and savings items, when the inflation rate warrants. For example, the maximum employee contribution amount to 401(k) and other employer-provided defined contributions remained unchanged from 2009 to 2010.
This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.