How Does a Cost-of-Living Adjustment (COLA) Affect My Salary?

A salary adjustment is a raise that is added to a person's salary to compensate for an increase in costs rather than to reward good performance. A cost-of-living adjustment (COLA) is a common type of salary adjustment, intended to compensate for an increase in inflation.

For many employees, salary adjustments are made at the discretion of their employer. These may compensate for inflation or increased costs due to an employee's relocation or reassignment.

Workers who belong to a union often have a cost-of-living adjustment, sometimes referred to as a cost-of-living allowance, built into their contracts. One example is a COLA adjustment required for U.S. Postal Service workers.

Social Security recipients are eligible for an annual cost-of-living adjustment subject to a review of changes in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). A 3.2% increase was approved for 2024.

How Salary Cost-of-Living Adjustments Are Calculated

The cost of living is the amount of money that is needed for an individual or a family to maintain an adequate standard of living, accounting for all of the necessities like housing, food, clothing, utilities, taxes, and healthcare.

Inflation (or the far less common deflation) changes the price of these necessities and can jeopardize the person's ability to maintain the same standard of living.

Measuring the Cost of Living

The computation involved in cost-of-living adjustments varies from employer to employer. Some employers may use the prior year's increase in the Consumer Price Index (CPI).

The Bureau of Labor Statistics (BLS) measures price inflation with the CPI. This index tracks changes in the prices of a set basket of consumer goods and services.

While CPI may be used by employers to calculate COLAs, the BLS website points out that the CPI is not meant to be a cost-of-living index. The Council for Community and Economic Research also provides a reputable Cost of Living Index.

Why Use a COLA?

Employers use COLAs to attract and keep valuable employees. A company that does not offer salary adjustments to offset inflation might find itself at a competitive disadvantage to companies that do offer this type of benefit.

Some companies offer another type of cost-of-living adjustment. This is a relocation adjustment offered to make employees willing to accept transfers to more expensive locations.

Cost-of-Living Adjustments for Relocations

Sometimes an employee may transfer to a new city while maintaining the same job and receive a salary increase to offset the higher cost of living in the new location.

If you are considering moving to another city to accept a new job, cost-of-living indexes can be used as an indicator of how suitable a salary offer is relative to your current income and standard of living. Housing, food, and taxes vary widely among states and cities.

Cities, regions, and states with a lower cost of living mean your income will go further. Moving to an area with a significantly higher cost of living can force a drastic downsizing in a family's lifestyle.

The Temporary COLA

Some employers arrange COLA adjustments on a temporary basis for short-term assignments away from home. This is particularly common in the military services.

In these cases, the adjustment or bonus pay may be more accurately described as a per diem allowance to cover a temporary and specific expense, such as higher rent.

The extra payment ceases when the temporary assignment ends, whereas a true COLA is a permanent salary increase.

COLA and Retirement Income

Over time, inflation in the prices of goods and services seriously erodes investment income and pension benefits for retirees living on a fixed income.

If monthly income remains relatively the same while basic costs—food, shelter, healthcare, taxes—increase, retirees who enjoy comfortable early retirements find themselves pinching pennies. Their income has remained the same but their purchasing power has been reduced.

Some forms of retirement fixed income increase with the cost of living, due to a built-in COLA. Income derived from COLA-based pensions, COLA-indexed pensions, and government benefits for retirees such as Social Security, will retain their purchasing power as inflation increases, as long as their COLA formula is sufficient. 

Annual Benefit Limit for Pensions

The IRS periodically updates the maximum benefit that participants can receive from a pension plan each year. The annual benefit for a defined benefit plan or pension must be less than $275,000 in 2024. That's an increase of $10,000 over the previous year.

Also, the annual benefit must be less than 100% of the participant's average compensation for their highest three consecutive calendar years. 

The Bottom Line

Cost of living is a measurement of the income needed to sustain a certain standard of living. Cost-of-living indexes track these costs over time and are used by many employers to adjust the salaries of their employees so that their real spending power does not decline.