If you receive Federal Disability Retirement benefits, you may have heard about cost-of-living adjustments, or COLA. A question many disability retirees may have is, “Why should I care about a COLA increase?” We found a good explanation by turning to the AARP (formerly known as the American Association of Retired Persons).
COLA Increases Help Retirees to Maintain Buying Power
As the AARP’s National Institute on Retirement Security describes in its “pension education toolkit,” a COLA increase is important because it helps you, as a retiree, to hold on to your buying power in the face of rising inflation.
COLA basically reflects inflation, or the higher prices you pay for your housing, transportation, food, clothes, entertainment, medical care and other goods and services.
Because inflation tends to rise every year, a COLA increase can be vital to maintaining the standard of living you enjoyed at the time of your retirement. Even modest rises in inflation can have a major impact in the long run.
The AARP provides an example: A woman retires at age 62 with a monthly retirement benefit of $2,000. If inflation increases at a rate of just 3 percent per year, her buying power will drop by 22 percent within eight years if there is no COLA. Instead of having $2,000 worth of buying power, it will be as if she has only $1,567.
When she reaches age 85 – if there is no COLA increase – the same woman’s buying power would plummet by more than half of its original value to $993.
So, as you can see, COLA can play a major role in how you enjoy your retirement years.
How Are They Determined?
COLA increases for retirees such as those receiving federal disability retirement benefits are determined by an established formula.
The COLA determination reflects the Consumer Price Index for Urban Wage Earners and Clerical Workers. The U.S. Bureau of Labor Statistics calculates this index, which is also called the CPI-W.
“[A] COLA effective for December of the current year is equal to the percentage increases (if any) in the average CPI-W for the third quarter of the current year over the average for the third quarter of the last year in which a COLA became effective.”
Any increase is rounded to the nearest 1/10 percent. If the rounded increase comes out to zero, or if there is no increase at all, there is no COLA.
Here’s how it works:
- CPI-W readings are taken from the 3rd quarter (July to September) of the current year
- Data is compared to the average CPI-W reading form the 3rd quarter of the previous year
- The average from the current year is compared to the figure from the 3rd quarter of the previous year
- If the average goes up in the current year, then the difference, rounded to the nearest 0.1%, is what beneficiaries receive as the increase
- If the figure is lower, due to deflation, no adjustment is made
How the COLA is determined depends on whether your receive CSRS or FERS benefits. Different formulas are used for each one.
For example, if you receive FERS benefits, your COLA increase will be:
- Equal to the CPI-W increase if that increase is 2 percent or less
- 2 percent if the CPI-W increase is more than 2 percent but less than 3 percent
- 1 percent less than the CPI-W increase if the increase is more than 3 percent.
- What determines the COLA?
According to the Bureau of Labor Statistics (BLS), these are the 8 most significant spending areas that have the highest impact on whether beneficiaries of the next COLA will receive an increase:
- Food and Beverage—cereal, milk, chicken, wine, full-service meals, snacks
- Housing—rent of primary residence, owner’s equivalent rent, fuel oil, bedroom furniture
- Apparel—men’s shirts and sweaters, women’s dresses, jewelry
- Transportation—new vehicles, airline fares, gasoline, motor vehicle insurance
- Medical Care—prescription drugs, medical supplies, physician’s services, hospital services
- Recreation—TV’s, toys, pets and pet products, sports equipment, admissions
- Education and Communication—college tuition, postage, telephone services, computer software and accessories
- Other Goods and Services—tobacco and smoking products, haircuts and personal services
*This is not an exhaustive list, merely examples.
This calculation doesn’t always work out well for retirees. Medical care is often one of the most important spending costs for COLA recipients; CPI-W doesn’t always consider the higher medical care and housing costs for seniors compared to younger people in the urban and clerical worker category.
Understanding how COLA increases are calculated and what factors influence them can help you better plan for your retirement years and understand how inflation may affect your buying power over time.
