Many pension benefits, employment contracts and government entitlements (such as Social Security) contain a cost of living clause such as a Cost of Living Adjustment (COLA) that increases payments based on changes in the cost-of-living index. Adjustments are typically made annually. They may also be tied to a cost-of-living index that varies by geographic location if the employee moves on company business.
Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as a cost-of-living allowance or cost-of-living increases because of their similarity to increases tied to externally-determined indexes and may be negotiated based on an increase in the Consumer Price Index (CPI). Thus the terms cost of living ADJUSTMENT and cost of living ALLOWANCE are often used interchangeably.
According to a study by the U.S. Bureau of Labor Statistics (BLS) Cost-of-living Adjustments (COLAs) clauses have fallen out of favor in many collective bargaining contracts lately with only 22% of contracts in private industry containing cost of living increase escalators in 1995 compared to 61% in 1976.
The BLS recommends that contracts specify exactly which CPI Index is to be used since there are several variations. The most common is the (CPI-U) which is calculated for All Urban Consumers and represents the purchasing patterns of about 88% of the population. The (CPI-W) on the other hand is calculated specifically for Urban Wage Earners and Clerical Workers, a subset of the CPI-U population, which represents about 29 percent of the U.S. population. There can be small differences in movement of the two indexes over short periods of time because differences in the spending habits of the two population groups result in slightly different weighting. The long-term movements in the indexes are similar. CPI-U and CPI-W indexes are calculated using measurement of price changes for goods and services with the same specifications and from the same retail outlets. The CPI-W is used for escalation primarily in blue-collar cost-of-living adjustments (COLA’s). Because the CPI-U population coverage is more comprehensive, it is used in most other escalation agreements.
Incidentally, the BLS has created an experimental CPI for the elderly, or CPI-E, by using households whose reference person or spouse is 62 years of age or older. In 2009–2010, approximately 24 percent of all consumer units met the CPI-E’s definition of having a reference person or spouse 62 years of age or older.
BLS Recommendations for Using the CPI as a Cost-of-living Adjustment (COLA).
The following are general guidelines to consider when developing an escalation agreement using the CPI:
DEFINE clearly the base payment (rent, wage rate, alimony, child support, or other value) that is subject to escalation.
IDENTIFY precisely which CPI index series will be used to escalate the base payment. This should include: The population coverage (CPI-U or CPI-W), area coverage (U.S. City Average, West Region, Chicago, etc.), series title (all items, rent of primary residence, etc.), and index base period (1982-84=100).
SPECIFY a reference period from which changes in the CPI will be measured. This is usually a single month (the CPI does not correspond to a specific day or week of the month) or an annual average. There is about a 2-week lag from the reference month to the date on which the index is released (e.g., the CPI for May is released in mid-June). The CPI’s for most metropolitan areas are not published as frequently as are the data for the U.S. City Average and the 4 regions. Indexes for the U.S. City Average, the 4 regions, 3 city-size classes, 10 region-by-size classes, and 3 major metropolitan areas (Chicago, Los Angeles, and New York) are published monthly. Indexes for the remaining 23 published metropolitan areas are available only on a bimonthly or semiannual basis. Contact the BLS address at the end of this fact sheet for information on the frequency of publication for the 26 metropolitan areas.
STATE the frequency of adjustment. Adjustments are usually made at fixed time intervals, such as quarterly, semiannually, or, most often, annually.
DETERMINE the formula for the adjustment calculation. Usually the change in payments is directly proportional to the percent change in the CPI index between two specified time periods. Consider whether to make an allowance for a “cap” that places an upper limit to the increase in wages, rents, etc., or a “floor” that promises a minimum increase regardless of the percent change (up or down) in the CPI.
PROVIDE a built-in method for handling situations that may arise because of major CPI revisions or changes in the CPI index base period. The Bureau always provides timely notification of upcoming revisions or changes in the index base.
For more information See:
- What is CPI?
- Inflation Rate Calculator
- Inflation Definition
- Misery Index– Inflation & Unemployment
- Inflation Charts A Picture is worth 1000 words
- Compare the cost of living between two cities
- Cost of Living: How Much of Your Budget Goes to Food?
- How to Calculate the Social Security Cost of Living Adjustment
- Living Longer: Health Care, Life Insurance and Retirement Costs
- Cost of Living – Fish and Chips- Infographic
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