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What Is A Cost Of Living Adjustment Or COLA?

What Is A Cost Of Living Adjustment Or COLA?

A Cost Of Living Adjustment, also known as COLA, is a mechanism by which individuals who collect government, company provided long-term disability or private supplemental income plans can receive increases in their payments over time. The increases however are not automatic but are tied directly to the Consumer Price Index or CPI and are allowed a maximum increase often limited to 3%. A situation that some retirees on Social Security or individuals on long-term disability can find themselves in, although it rarely happens, can be no COLA increases. The reason for this can be that slow economic times often result in little to no inflation. Since inflation is nonexistent then consumer prices do not increase and as a result there is no cost-of-living adjustment.

Why is there a cost-of-living adjustment in the first place? It is a common refrain by many financial planners and investment professionals to advise their clients to make their money work for them. This is because savings accounts often have such low yields that they will be outpaced by inflation. This means their money will actually lose value over time if inflation increases at historical rates of between 2% and 3% annually. If a savings account is only making 0.5% in interest then the value of money in that account could be decreasing by 2.5% each year. This same methodology applies to Social Security and long-term disability payments in that they lose value over time if payments are not adjusted for inflation using a cost-of-living mechanism.

During times of economic stagnation and decreases in consumer spending, interest rates set by the Federal Reserve are often lowered to make borrowing more attractive and increase demand. In certain circumstances, interest rates can be lowered to such an extent as to have a zero effective rate. This can only be done in times where inflation is also zero or there's the threat of deflation. If this is the case then consumer prices don't increase and a Social Security check or long-term disability check has the same effective purchasing power. If these supplemental income programs can still purchase the same amount of goods for the same prices then there is no need to implement a cost-of-living adjustment. While this upsets supplemental income recipients it is common sense financial and economic analysis which is indisputable.

While government-backed programs offer cost-of-living adjustments as necessary based on increases in the consumer price index, employer-based or private programs may not offer this feature by default. It may be necessary for individuals to purchase a separate additional benefit, especially in the case of long-term disability insurance, if they are worried about a decrease in their purchasing power over time. While it may not be a deciding factor in purchasing private long-term disability insurance it could be an important characteristic which may alter purchasing behavior. This will make LTD insurance coverage more expensive but if you anticipate extended use of long-term disability then the upward adjusted increases in payments may be worth the additional expense.

A cost-of-living adjustment or COLA is an important consideration for individuals receiving supplemental or primary income over many years. Without this mechanism, purchasing power can decrease and within a few years time could have significant implications in respects to paying for medicine and utilities. A cost-of-living adjustment is important as it prevents individuals on fixed incomes from becoming worse off financially as time passes.

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