What is a cost-of-living adjustment (COLA)?

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If you’re one of the more than 70 million people receiving Social Security benefits, you probably pay close attention to the cost-of-living adjustment, or COLA, which is announced in October each year. The COLA is a change in your monthly benefit to ensure that your purchasing power remains the same even when prices rise due to inflation. In 2020, the Social Security Administration announced that the COLA for 2021 benefits would increase by 1.3 percent.

Here’s how the COLA is figured and who receives the benefit.

How the COLA is calculated

By law, the cost-of-living adjustment is based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), a measure of inflation calculated by the Bureau of Labor Statistics (BLS).

To figure the index, the BLS administers a consumer expenditure survey to collect information every three months from approximately 7,000 individuals and families about the things they buy regularly — everything from personal care products to vehicle registration fees.

BLS data collectors then call retail stores, doctor’s offices and service establishments to determine the price changes for the approximately 80,000 items included in the CPI-W.

If there is no change in the CPI-W — which was the case in 2015 — there is no COLA for the following year. In 2016, there was a small increase of 0.3 percent, which went into effect at the start of 2017.

Here’s the COLA announced in each year by the Social Security Administration.

Year COLA increase Year COLA increase
2020 1.3% 2015 0%
2019 1.6% 2014 1.7%
2018 2.8% 2013 1.5%
2017 2.0% 2012 1.7%
2016 0.3% 2011 3.6%

Source: Social Security Administration

The CPI-W and how it is calculated are sometimes the subject of debate. For instance, because it is based on a basket of products reflecting the spending of younger, working people, some critics say it doesn’t accurately measure the inflation experienced by older retirees who may purchase more prescription drugs and medical services.

So a year with a low increase – or none at all – may really hurt Social Security recipients.

Why a COLA increase is so important

While COLA increases may seem paltry, even a small adjustment makes a big difference in the value of your dollar over time. For instance, while inflation has been extremely low for the past 10 years, it has averaged around 2.3 percent a year from 1990 to 2019.

How big a difference can 2.3 percent inflation make? Let’s say you retire today at age 62 with a $2,000 monthly benefit. With inflation at 2.3 percent, you’d lose 25 percent of your purchasing power when you hit 74. Another 10 years and your purchasing power would fall by a total of 40 percent. So at age 84 without a COLA it would feel like living on $1,200 today.

Stashing money in a high-yielding certificate of deposit or a savings account is one way to help beat inflation. But it’s useful to have a diversified portfolio of investments that can grow over time and potentially earn more, helping you grow your purchasing power.

Keep in mind that inflation could rise much higher than it has in the more recent past. There have been times—such as in the 1970s when legislation was enacted to provide COLAs—when inflation was in the double digits. For people living on a fixed income, the COLA is a critical safety net.

But assuming Social Security will cover all your bills in retirement is one of the biggest mistakes that near-retirees make with the program.

Who receives a COLA?

While Social Security retirement recipients are the largest group to benefit from a COLA, they aren’t the only ones. Individuals receiving Supplemental Security Income, a federal program to help seniors age 65 or older, blind and disabled people, and individuals receiving disability payments also get COLAs.

Military and Federal Civil Service retirees have cost-of-living adjustments as well, and some unions negotiate COLAs in their contracts. Finally, eligibility for such government programs as food stamps and free school lunches is also tied to changes in the CPI-W.

Bottom line

A cost-of-living adjustment provides a key way that Social Security recipients and others can avoid having their purchasing power decline significantly over time. Those investing for retirement need to ensure that they have money there when they need it, which is why it’s so critical that workers not be too conservative in their investments.

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Note: Kevin Channing contributed to a previous version of this story.