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Understanding Cost of Living Adjustments (COLAs) and Their Impact on Retirement Income, Lecture notes of Finance

This fact sheet explains what colas are, why they matter for retirees, and how they help maintain purchasing power in the face of inflation. It also discusses the importance of proper funding for colas and their impact on retirement systems.

Typology: Lecture notes

2021/2022

Uploaded on 09/27/2022

ekavaria
ekavaria 🇺🇸

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You may have heard some talk recently about the COLA
in your pension plan. You may have wondered: What is
a COLA? How much do COLAs matter? If the COLA
changes, will I be impacted? What do these trends mean
for my retirement? This fact sheet provides some basic
information that might help.
A cost of living adjustment (COLA) is a change in one’s
monthly retirement benefit to account for increasing prices.
COLAs help to ensure that your purchasing power remains
the same no matter how long you may live, and how quickly
prices might rise.
For example, if your retirement benefit is $1,000 per month,
you can purchase a certain amount of goods or services with
that income—groceries, prescriptions, utilities, etc. However,
if the prices of those goods and services increase by, say, 3% in
a single year, you can purchase fewer goods with that $1,000
benefit—your “purchasing power” has declined.
If you receive a COLA based on this increase in prices,
however, then this year’s benefit would increase to $1,030 per
month. Thanks to your COLA, you will
have the same purchasing
power—or the
same ability to
purchase those
same goods—that
you did last year
with your $1,000
benefit.
Cost of Living Adjustments (COLAs)
A cost of living adjustment
(COLA) is a change in one’s
monthly retirement benefit to
account for increasing prices
or inflation.
When it comes to COLAs…
Rising prices and inflation can
very quickly erode the value
of retirement income. Even
a modest rate of inflation
can significantly impact your
purchasing power over time, if
your benefit does not include a
COLA.
COLAs are very important,
because they help to ensure
that retirees’ purchasing power
is maintained, no matter how
long they may live, and how
quickly prices might rise.
COLAs may be even more
important to those retirees who
do not receive Social Security
benefits, because without their
pension COLA they are likely
to have no other retirement
income that increases with
inflation.
While COLAs provide important
protections for retirees, they do
cost money. Any COLA benefits
that are promised should be
pre-funded, or paid for in the
year that they are given.
Purchasing Power
with a COLA
Purchasing Power
without a COLA
Understanding COLAs
NRTA PENSION
EDUCATION TOOLKIT
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You may have heard some talk recently about the COLA

in your pension plan. You may have wondered: What is

a COLA? How much do COLAs matter? If the COLA

changes, will I be impacted? What do these trends mean

for my retirement? This fact sheet provides some basic

information that might help.

A cost of living adjustment (COLA) is a change in one’s monthly retirement benefit to account for increasing prices. COLAs help to ensure that your purchasing power remains the same no matter how long you may live, and how quickly prices might rise. For example, if your retirement benefit is $1,000 per month, you can purchase a certain amount of goods or services with that income—groceries, prescriptions, utilities, etc. However, if the prices of those goods and services increase by, say, 3% in a single year, you can purchase fewer goods with that $1, benefit—your “purchasing power” has declined. If you receive a COLA based on this increase in prices, however, then this year’s benefit would increase to $1,030 per month. Thanks to your COLA, you will have the same purchasing power—or the same ability to purchase those same goods—that you did last year with your $1, benefit.

Cost of Living Adjustments (COLAs)

A cost of living adjustment (COLA) is a change in one’s monthly retirement benefit to account for increasing prices or inflation. When it comes to COLAs…

  • Rising prices and inflation can very quickly erode the value of retirement income. Even a modest rate of inflation can significantly impact your purchasing power over time, if your benefit does not include a COLA.
  • COLAs are very important, because they help to ensure that retirees’ purchasing power is maintained, no matter how long they may live, and how quickly prices might rise.
  • COLAs may be even more important to those retirees who do not receive Social Security benefits, because without their pension COLA they are likely to have no other retirement income that increases with inflation.
  • While COLAs provide important protections for retirees, they do cost money. Any COLA benefits that are promised should be pre-funded, or paid for in the year that they are given. Purchasing Power with a COLA Purchasing Power without a COLA Understanding COLAs

NRTA PENSION

EDUCATION TOOLKIT

COLAs may not seem so significant—you may wonder, how important is just $30 per month? Yet rising prices and inflation can very quickly erode your retirement income, even to the point that a retirement benefit that was perfectly adequate to pay your monthly expenses when you retired can become inadequate over time. Like water cutting though a rock, even a modest rate of inflation can significantly erode your purchasing power over time.^1 Figure 1 shows the rate of inflation in the U.S. for every year since 1982. The graph clearly shows that inflation has been positive in every year, except

  1. The average rate of inflation in this 30 year period has been nearly 3% annually (3.04% to be exact).^2 Again, an increase in prices of 3% per year may not seem so significant at first. But your purchasing power can be eroded quite substantially over time due to even relatively small levels of inflation, if you do not have a COLA. For example, let’s say that a woman retires at age 62, with a benefit of $2, per month. And let’s say that inflation averages about 3% per year after she retires. Figure 2 shows the impact that this 3% annual inflation rate has on her purchasing power. Without any type of COLA, this woman’s purchasing power will fall to about $1,500—a 22% drop!—by age 70. By the time she reaches age 85—which happens to be her average life expectancy—her purchasing power will fall to just $993—less than half the value of her initial benefit. Again, this means that she will be able to purchase only half the amount of goods that she was able to buy when she retired. And if she were to live past 85, she would experience even greater reductions in purchasing power. Luckily, the damaging effects of inflation are well understood, and most state and local retirement systems do offer COLAs, although they can vary in how they are designed.^3 In some cases, the COLA is prescribed—for example, a fixed 3% per year, or an amount tied to increases in the Consumer Price Index (a measure of the average price of a fixed basket of consumer goods). This type of COLA provides retirees with the security that no matter how much inflation may go up, their benefits will keep the same value. In other words, they will always have the same purchasing power. COLAs can also be ad-hoc in nature, which means that they are granted at the discretion of the state each -1.0% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 1982 1988 1994 2000 2006 2012 Figure 1. Annual Inflation Rate, 1983- Even Modest Inflation can Significantly Erode Purchasing Power Figure 2. The Effect of 3% Inflation on a $2,000 Benefit $ $ $1, $1, $2, $2, 62 70 85 $2, $1, $ NRTA Pension Education Toolkit | Cost of Living Adjustments (COLAs) 2