A:

Some companies build salary adjustments into their compensation structures to offset the effects of inflation on their employees. Cost-of-living adjustments, or COLAs, can also refer to annual adjustments made to Social Security and Supplemental Security Income, which are generally equal to the percentage increase in the consumer price index for urban wage earners and clerical workers, or CPI-W, for a specific period.

Workers who belong to a union may have a cost-of-living adjustment, sometimes referred to as a cost-of-living allowance, built into their contract. One famous example is the COLA required for U.S. Postal Service workers. For most employees, though, cost-of-living adjustments are awarded at the discretion of their employer.

How Salary Cost-of-Living Adjustments Are Calculated

Cost of living refers to the amount of money required to maintain a standard of living, accounting for basics like housing, food, clothing, utilities taxes and healthcare. Increases (or decreases) in the price of these necessities affect the cost of maintaining your lifestyle, and this, in turn, shapes how well your income will support you and your dependents.

The computation involved in cost-of-living adjustments can vary from employer to employer. There is no official cost-of-living metric provided by the federal government, but some employers may use the prior year's rise in the Consumer Price Index, or CPI.

The Bureau of Labor Statistics measures price inflation with its CPI, which measures temporal changes in a set basket of consumer goods and services. The methodology behind the CPI has changed over time, and there is some debate about whether it is a reliable indicator of real inflation levels. While CPI may be used by employers to calculate COLAs, the official BLS website points out that the CPI is not meant to be a cost-of-living index.

The Council for Community and Economic Research also provides a reputable Cost of Living Index.

In general, employers use COLAs to attract and keep valuable employees. A company that does not offer salary adjustments to offset inflation might find itself at a competitive disadvantage to companies that do offer this type of benefit to employees.

There is another type of cost-of-living adjustment not directly tied to the rate of inflation, but employers may offer it to make employees more willing to accept job transfers.

Cost-of-Living Adjustments for Relocations

Sometimes an employee may transfer to a new city while maintaining the same job and receive a salary increase to offset the higher cost of living in the new location. An example is an employee who receives a salary increase because he is transferred from Chicago to New York City where consumer goods and services are more expensive. (For more, see "Know Cost of Living B4 Taking a Relocation Package.")

If you are considering moving to another city to accept a new job, cost-of-living indexes can be used as an indicator of how suitable a salary offer is relative to your current income and standard of living. Housing, food and taxes vary between states and even regions. Cities, regions and states with a lower cost of living usually mean your income will go further. Living in areas with a higher cost of living usually mean workers have less disposable income, or money in their bank accounts, after paying for the basics and need higher incomes to live as well as they would in a less costly region. 

Sometimes the term COLA is used to describe salary "adjustments" or allowances for workers, including military personnel temporarily relocated to another city, region or country. Though the idea is to compensate workers for a change in their welfare resulting from moving to a different location, the adjustment or bonus pay may be more accurately described as a per diem allowance to be used for a temporary and specific cost, such as a higher rent payment. The extra payment does not continue when the temporary assignment ends, whereas a true COLA for a permanent salary remains in place.

COLA and Retirement Income

Over time, inflation and increasing prices for goods and services can seriously erode investment income and pension benefits for retirees living on a fixed income. If  monthly income remains relatively the same while basic costs – food, shelter, healthcare, taxes – increase, retirees who enjoyed comfortable early retirements may find themselves pinching pennies as time goes on. This is because their purchasing power has been eaten away by inflation.

Some forms of retirement fixed income do increase with the cost of living, due to a COLA. Income derived from COLA-based pensions, COLA-indexed pensions and government benefits for retirees, such as Social Security, will retain their purchasing power as inflation increases,as long as their COLA formula is sufficiently generous. (For more on Social Security COLAs, see "Is the Cost-of-Living Adjustment Mandatory?")

The Bottom Line

The phrase "cost of living" refers to a measure of the cost of sustaining a certain standard of living. Cost-of-living indexes can be used to compare salaries across different areas. A cost-of-living adjustment calculation may be used to increase certain kinds of income such as contracts, pensions or government benefits so they can keep up with increasing basic living costs, as represented by the CPI or a cost-of-living indexes. In general, cost-of-living adjustments to your salary wil be determined by your employer.

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