Definition
The term cost-of-living adjustment refers to a periodic change to a benefit based on an index thought to be a good measure of living expenses. Cost-of-living adjustments (COLA) normally refer to an increase in an individual's income stream, which can be Social Security or a salary provided by an employer.
Calculation
While companies have some latitude in determining how their COLA is calculated, the exact approach is usually documented and does not vary over time. The Social Security Act specifies the exact formula that applies to Social Security and Supplemental Security Income (SSI) benefits, which uses the annual increase to the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). This index is published each month by the Bureau of Labor Statistics. The formula used to compute the COLA is as follows:
COLA (%) = ((CPI-WC - CPI-WP) / CPI-WP) x 100
Where:
CPI-WC = the three month average of the Consumer Price Index for Urban Wage Earners and Clerical Workers in the current period.
CPI-WP= the three month average of the Consumer Price Index for Urban Wage Earners and Clerical Workers in the prior period; this is the last period in which a COLA was granted.
Note: The COLA applied to Social Security is rounded to the nearest 0.1%.
Explanation
Also referred to as COLA, the term cost of living adjustment is normally associated with an annual increase to an individual's stream of income, which includes Social Security, pension benefits, as well as the salary received from an employer. The purpose of this increase is to ensure an individual's purchasing power, and standard of living, does not degrade significantly over time.
The exact calculation for a cost-of-living adjustment can be determined by statute, or a company's past practice. The formula used to calculate the COLA will utilize a well-established measure of inflation, which is oftentimes the Consumer Price Index, or CPI.
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