Think Twice Before Counting on a COLA

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The rising costs of food, gas, electricity and health care can strain anyone’s budget. The situation is even worse if your living expenses increase while your income stays the same. That’s why cost-of-living adjustments, or COLAs, are especially valuable to retirees and others living on fixed incomes.

How COLAs work
It’s easy to think of a COLA as a “raise,” but a COLA is meant to help you maintain your standard of living, not improve it. For example, let’s say you receive a $2,000 monthly retirement benefit, and the overall cost of the things you need to purchase increased by 3% during the year. The next year, you receive a 3% COLA, or an extra $60 a month, to help manage rising prices.

That 3% COLA doesn’t sound like much, but without a COLA, inflation can seriously erode your retirement income. Assuming a 3% inflation rate, in just 10 years, the purchasing power of your monthly $2,000 benefit would drop to $1,520; in 25 years, it would only be $963.

Who receives COLAs?
Social Security is the major source of inflation-protected retirement income for many Americans. COLAs are also commonly paid to retirees who are covered by state or federal pensions. However, most private pensions do not offer COLAs.

Less commonly, employers may offer COLAs as part of compensation packages. For an additional cost, you might be able to purchase riders for certain insurance policies (such as disability income and long-term care policies) to ensure the benefits you receive keep pace with inflation (subject to contractual terms and conditions).

When there is no Social Security COLA
Social Security COLAs are officially announced each October and reflect the annual increase in the average Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The average CPI-W for the third calendar quarter of the last year a COLA was payable is compared to the average CPI-W for the third calendar quarter of the current year. Any percentage increase that results is the COLA for that year and will be payable to beneficiaries beginning in January of the following year. However, beneficiaries will not receive a COLA if there is no increase in the average annual CPI-W.

No COLA for Social Security beneficiaries also means no increase in two Social Security limits: the contribution and benefit base (also called the Social Security wage base) and the retirement earnings test exempt amounts.

The contribution and benefit base is the cap on the annual amount of wages and self-employment income subject to Social Security payroll taxes. The retirement earnings test applies only to people under full retirement age who receive Social Security benefits and also have earnings from work.

Putting COLAs in perspective
COLAs are vulnerable to cutbacks. Consider taking additional measures to account for the effect of long-term inflation. Use realistic inflation and investment return assumptions when planning for retirement, maintain a diversified portfolio that reflects your time horizon and risk tolerance and consider investments that have historically held their own against inflation. 

 Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016.

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