What is a 'Cost-of-Living Adjustment - COLA'

An adjustment made to Social Security and Supplemental Security Income to counteract the effects of inflation. Cost-of-living adjustments (COLAs) are generally equal to the percentage increase in the consumer price index for urban wage earners and clerical workers (CPI-W) for a specific period.

For example, if Kevin received $10,000 last year in Social Security benefits and the COLA for this year is 4.1%, his benefits for this year would be $10,410.

BREAKING DOWN 'Cost-of-Living Adjustment - COLA'

During the 1970s, inflation was very high. As a result, compensation-related contracts, real estate contracts and government benefits used COLAs to protect against inflation.

The Bureau of Labor Statistics (BLS) determines CPI-W, which is used by the Social Security Administration (SSA) to compute COLAs. The COLA formula is determined by applying the percentage increase in the CPI-W from the third quarter of one year to the third quarter of the following year.

Congress ratified a COLA provision to offer automatic yearly COLAs based on the annual increase in CPI-W that went into effect in 1975. Prior to 1975, Social Security benefits were increased when Congress approved special legislation. In 1975, COLAs were based on the increase in the CPI-W from the second quarter of 1974 to the first quarter of 1975. From 1976 to 1983, COLAs were based on the increases in the CPI-W from the first quarter of the previous year to the first quarter of the current year. Since 1983, COLAs are dependent on the CPI-W from the third quarter of the previous year to the third quarter of the current year.

Inflation levels were high in the 1970s ranging from 5.7 to 11.3% in 1979. In 1975, the COLA increase was 8%, and the inflation rate was 9.1%. In 1980, COLA reached the highest level in history at 14.3% while the inflation rate was 13.5%. Amid the 1990s, drastically lower inflation rates prompted small COLA increases averaging 2 to 3% per year.

The Effects of COLA on Recipients

COLA is reliant on two components: the CPI-W and the employer contracted COLA percentage. CPI determines the rate of inflation and is compared yearly. When consumer prices drop or if inflation has not been high enough to substantiate a COLA increase, recipients do not receive COLA. If there is no CPI-W increase, there is no COLA increase.

When a COLA increase is not approved, Medicare Part B premiums remain the same for about 70% of beneficiaries who get the premiums deducted from their Social Security checks. However, the remaining recipients such as those with higher incomes, those who did not participate in Social Security through their employer and new beneficiaries must pay the Medicare Part B premium increases.

Other Types of COLAs

Some employers such as the U.S. military occasionally give a temporary COLA to employees who are required to perform work assignments in cities with a higher cost of living than where they presently live. The COLA expires when the work assignment is finished.

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