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
Image courtesy of ddpavumba / FreeDigitalPhotos.net
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Cindy Day says
Hi! Tim, Is CPI typically used in a Business Lease? We are a non profit organization in California. We had a building that needed work and was not being used . So we leased it out to a for profit daycare/preschool for 15 years. They made all necessary repairs and updates and we split the cost down the middle. They suggested we use CPI for annual rate increases. We agreed, even though we weren’t very familiar with the method. After 5 years we are only seeing minimal increases. Now, they have an interest in leasing additional space in the building which is exactly the same size. we are trying to figure out a fair way to include annual increases on a new yearly lease or 10 year lease. What is the best option for rental increases? Should we continue with using CPI or is there are better method that you would suggest. Also what is the current CPI?
Tim McMahon says
Yes, the CPI is the typical inflation adjuster used in most contracts. Because of exceptionally low Oil prices the CPI has not increased as much as it usually does but that will probably change before long. I would use the CPI as an adjuster in the new lease as well but not necessarily start the new lease at the same price as the old lease just because it is the same size. If you feel the CPI didn’t keep up with the average real estate prices in your neighborhood you should use comparable real estate values (comps) to establish your initial price. You can always find the Current CPI in the top “Ticker Bar” on any page on our site.
Hi Tim ,
I would appreciate if you can help with the following. I’m from the middle east; we have a contract with a government to sell them some products.A reference value for CPI was 1999=100 as a base year. All of the sudden the government has changed the base year to 2007=100 wef 2014. The ratio of local currency adjustment has reduced from 144.9/99.6 to 128.3/93.6 for 2014 and onwards. This caused us subjected to a significant revenue loss.
My questions are
1- What is the worldwide accepted practice in such case?
2- Is there any other better adjustment methodologies to propose as an amicable solution between both parties?
3-Does such action from the government is legally accepted if we choose to go arbitration with independent Expert.
Tim McMahon says
Just because they changed the scale shouldn’t affect the resulting inflation. The U.S. has changed the base date a few times. The last on was back in 1982. But your contract shouldn’t be affected. Let’s assume the following two series. Series 1 base 1999. 1999=100, 2000=101, 2002=102, 2003=103, 2004=104, 2005=105, 2006=106, 2007=108, 2009=109 and 2010=110. So inflation from 1999 through 2010 was (110-100)/100 or 10/100 or .1 which equals 10%.
Now assuming that the government didn’t use the change of scale to fudge the inflation rate (a big assumption), it should still work out so that inflation from 1999 through 2010 was still 10%. The numbers won’t be as even but if 2010 was now 103, 1999 should come out to be somewhere around 93.6. The formula would now look something like this (103-93.6)/93.5= (9.4)/93.6= 0.1004 which is 10.04% my numbers are a little off. The actual number for 1999 would be a little higher than 93.6 to make it still come out to 10% from 1999 through 1010. Hope this helps.
Rhudi Eagle says
How do I apply for the cost of living in my alimony in New York city I have not gone A increase cost of living in my alimony for 30 years I depend on that alimony which is so little because he has been constantly not giving me the alimony payments for the last 30 years and could not afford a lawyer and lawyers wouldn’t take my case because it wasn’t money making for them
Tim McMahon says
Alimony is like any other contract except that it needs court approval before it becomes effective. And most contracts can’t be changed once they are put in force. So if you want a cost of living adjustment you would need to put it in place when the contract is first created not 30 years later. However, whether you have a cost of living adjustment or not doesn’t matter if payments aren’t being made. Generally, the courts are the only way to enforce alimony payments. However if you can’t find a lawyer willing to to take your case it is highly likely it is because your “EX” doesn’t have enough money to make it worth a lawyer’s time to prosecute. As the old saying goes, “You can’t get blood from a stone”.