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The cost of living is the amount of money an individual or a family needs to maintain an adequate standard, accounting for necessities like housing, food, clothing, utilities, taxes, and healthcare.
A cost-of-living adjustment (COLA) is a type of salary adjustment intended to compensate for an increase in inflation or alleviate the increased costs due to an employee’s relocation or reassignment.
Key Takeaways
- Cost-of-living adjustments help employees and retirees maintain their purchasing power.
- Salary adjustments may incentivize an employee to move to a location that has a higher cost of living.
- The annual Social Security COLA is calculated using the Consumer Price Index.
How a COLA Is Calculated
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 may also offer a relocation adjustment to make employees willing to accept transfers to locations where living is more expensive.
Inflation increases the price of consumer staples and can jeopardize a person’s ability to maintain their standard of living or quality of life. Cost-of-living adjustments vary from employer to employer. 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.
Some employers may use the prior year’s increase in the Consumer Price Index (CPI). 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.
2.3%
The increase in the Consumer Price Index from April 2024 through April 2025.
Adjustments for Employees
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. Cost-of-living indexes can be used as an indicator of how suitable a salary offer is relative to an individual’s current income. Housing, food, and taxes vary widely among states and cities.
Some employers arrange COLA adjustments temporarily for short-term assignments. This is particularly common in the military services. 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. This extra payment ceases when the temporary assignment ends, whereas a true COLA is a permanent salary increase.
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.
COLA and Retirement Income
Inflation can erode investment income and pension benefits for retirees living on a fixed income. If monthly income remains the same while basic costs like food, shelter, healthcare, and taxes increase, retirees may find themselves pinching pennies as their purchasing power is reduced.
Some forms of retirement have a built-in COLA. Income derived from COLA-based pensions, COLA-indexed pensions, and government benefits like Social Security will retain their purchasing power as inflation increases.
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. A 2.5% increase was approved for 2025.
Warning
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 $280,000 in 2025.
How Is the Social Security COLA Determined?
The Social Security cost-of-living adjustment for 2025 was 2.5%. It is based on the percentage increase in the CPI from the third quarter of 2024.
Does Everyone Get the Social Security COLA Increase?
All recipients of Social Security benefits receive the COLA increase to account for inflation.
At What Age Is Social Security No Longer Taxed?
Individuals with no other income pay no federal taxes on their Social Security income. If their combined income from all sources exceeds $25,000 (or $32,000 for a couple), a portion of Social Security income is taxable. The taxable portion is 50% or 85% of their benefit, depending on total income.
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 their real spending power does not decline.
