What Are COLAs and How Do They Affect Retirement Carmichael Hill

If you are currently receiving Social Security or considering how Social Security might factor into your retirement plan, then it’s important for you to understand COLAs. You may have seen the acronym in various information about Social Security, and you may have wondered what it meant. Well, let’s answer your questions about the term.

What is a COLA?

COLA stands for “cost of living adjustment.” [1] It amounts to an automatic increase in benefit payments from a pension or Social Security to counter inflation.[1] Different pensions may use different metrics to calculate the inflation number that COLAs are based on, but the most common is the Consumer Price Index (CPI). Consider Social Security, which bases its COLAs on the CPI-W, which is the consumer price index for urban wage earners and clerical workers. This inflation gauge is calculated from the prices for common goods everyone buys, such as food, clothing, medicine, shelter, and fuel, among other things.[2]

When the CPI-W rises, the Social Security Administration pays out an increase in benefits to all Social Security recipients (i.e. a COLA).

How Do COLAs Work?

In a nutshell, the COLA is a way that your Social Security will be adjusted automatically to increase based on the current prices of goods and services. Remember, COLAs are designed to keep your payments feeling level. Over time the COLAs will continue to grow, but it doesn’t necessarily mean you will feel any richer. These are designed to alleviate the pain from inflation. This means that $4,000 monthly benefit ten years from now may feel no different than a $3,000 monthly benefit today after factoring in higher costs of living.

So, what happens when your COLA doesn’t keep pace with the cost of living?

This is a problem without an easy solution. The CPI-W is representative of about 30% of US consumers,[4] but even that varies. You may spend more on medicine than others depending on your health, or perhaps more on fuel if you live in a rural area or housing if you live in an urban area. COLAs are a one-size fits all solution applied to millions with widely varying individual needs. They’re helpful, but they aren’t a silver bullet.

When COLAs aren’t enough

Beyond a COLA, defined benefit plans such as pensions and Social Security also provide actuarial adjustments when you defer taking benefits. Payments are determined based on an average estimated lifespan. Every year that you wait is one less year that they have to pay you. You don’t get less money for waiting – it’s still the same estimated lifetime payment but now it’s spread out over a fewer number of years. This means that your payments generally increase for every year that you wait to claim benefits. The opposite is true when you claim benefits early. Payments will be less than if you wait.

With Social Security specifically, you can claim benefits as early as age 62 or as late as age 70. You receive a roughly 8% monthly benefit increase for every year you wait to claim and an 8% reduction for every year you claim benefits prior to your Full Retirement Age. If you don’t believe COLAs will be enough to get you through retirement, then it may be worthwhile to consider delaying taking your Social Security and pension payments to a later date.

Retirement has many rules and different elements that can be important to know. If you are looking for a guide to help you navigate your retirement planning, then reach out and give us a call. We’ll schedule a complimentary consultation to review your finances and address your concerns around Social Security and retirement.

 

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