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Cost of Living Adjustment: History & Formula

Cost of Living Adjustment: History & Formula
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  • 0:03 The Cost of Living Adjustment
  • 0:58 History of Adjustments
  • 1:50 How to Calculate COLAs
  • 3:01 Example
  • 4:01 Determining the New Benefit
  • 4:33 Lesson Summary
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Lesson Transcript
Instructor: Michael Cozad

Michael is a financial planner and has a master's degree in financial services.

In this lesson, the history and formula of the Cost of Living Adjustment is explored. You'll also learn how to apply the Cost of Living Adjustment to a Social Security benefit payment.

The Cost of Living Adjustment

The Cost of Living Adjustment is an annual change that occurs in salaries or benefit payments as a result of an increase in a cost-of-living index. This lesson will focus on the Cost of Living Adjustment (COLA) specific to the Social Security Administration benefit program.

You may have heard a family member reference that they would be getting an increase in their monthly Social Security check. This automatic increase is a result of the Cost of Living Adjustment formula the Social Security Administration, authorized by Congress and signed into law by President Nixon in 1972, has instituted. It's important for those receiving Social Security benefit checks that they receive increases in their payment because inflation can diminish purchasing power over time. For example, the cost of a loaf of bread in 1970 was 25 cents and in 2013 it was $1.98. This is due to inflation.

History of Adjustments

Let's go back in time for a moment. Social Security began issuing checks in January 1940. It wasn't until 1950 when the first Cost of Living Adjustment was received. This first increase in benefits was effective for the September 1950 benefit checks, which were received in October 1950.

Legislation was again passed in September 1952 to increase benefits. It's important to note that these increases in benefits were not automatic; Congressional legislation permitted them. Then, in 1972, President Nixon signed automatic Cost of Living Adjustments into law, beginning in 1975, based on the annual consumer price increases. This was a significant milestone for Social Security benefit recipients, as they no longer had to wait until legislation was passed by Congress to receive an increase in their benefit payment.

How to Calculate COLAs

Cost of Living Adjustments are based on increases in CPI-W, or the Consumer Price Index for Urban Wage Earners and Clerical Workers. The U.S. Bureau of Labor Statistics calculates the CPI-W index monthly. COLAs are effective for December of the current year, and those benefits are paid in January of the following year. The Cost of Living Adjustment is the percentage increase 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.

If there is a percentage increase, it's rounded to the nearest one-tenth of one percent. There is no COLA if there is no percentage increase or if the increase, rounded to the nearest one-tenth of one percent, is zero.

The formula can then be written as:

(A - B) / B * 100 = i

where:

A = Average CPI-W for 3rd quarter of current year

B = Average CPI-W for 3rd quarter of the last year in which the COLA was effective, which may or may not have been the previous year

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