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Caution on the COLA [ClearOnMoney]
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Caution on the COLA

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Commentary

Caution on the COLA

12 Feb 2013 by Jim Fickett.

Most people have poor intuition regarding inflation. The role of a pension in retirement planning is one area where this can lead to trouble. For example, one of the larger pension plans in the US has a complicated formula for the cost of living adjustment (COLA) that, over a period of 3 decades covering the last major US inflation, would have reduced the value of a pension by half.

The University of California retirement system has a rather complicated rule for the annual cost of living adjustment (COLA):

For annual inflation between 0% and 2%, the full inflation rate is applied.

For inflation between 2% and 4%, a COLA of 2% is applied.

For inflation above 4%, 3/4 of the amount above 4% is added to 2%.

But the COLA is capped at 6%.

For example, with inflation of 3%, the COLA is 2%. For inflation of 6%, you get the base 2% plus 3/4 of the amount above 4%, or (2 + 0.75*2)% = 3.5%. In 1980 annual inflation was 13.5%; one first calculates the rate according to the third rule, (2 + 0.75*9.5)% = 9.1%, but then reduces this to 6% by the fourth rule.

Here is a graph of the historical inflation rate from 1966 to 1996, and the COLA that would have been applied each year if this rule had been in effect at that time:

In the worst years even the average person might notice the difference between price rises and pension increases. But it is the cumulative effect that is really striking.

Over time the small changes compound and, after 3 decades (not an unusual length of retirement these days), the value of the pension would have been cut in half. The cumulative payout over the full time span shown would have been about 70% of the amount someone would have gotten with the full CPI as COLA.

This is only one example. The topic is general, however. Many pension plans have no COLA at all and some of those that do are attempting to reduce it, as this is a change less apparent to plan members than, say, an increase in current contributions. The National Conference of State Legislatures wrote last year:

Six states have reduced the schedule for cost-of-living increases for retirees in the last two years, and six others have done so in ways that will affect current employees when they retire. Since cost-of-living increases are expensive, reducing them provides immediate savings and a long-term reduction in the total liabilities of a pension plan. Is this legal? All three of the states that reduced cost-of-living adjustments in 2010 were sued, and suits over the 2011 legislation certainly are possible. Courts in Colorado and Minnesota ruled in favor of the reductions, although the Colorado decision will be appealed.

So before you count on a pension, check the fine print, and keep an eye on court precedents.