COLAs, Inflation and Planning Your Retirement

Federal retirees receive an annual cost of living increase indexed to inflation, but the inflation index may not reflect your true cost of living.

If you are a federal retiree, you receive an annual cost of living increase that is indexed to inflation. It is automatic although the amount you actually receive will vary depending on whether you are in the FERS or the CSRS system.

Some readers who are still working for Uncle Sam refer to their annual raise as a COLA. And, while inflation is a factor in the annual political debate about the next federal pay raise, it is not a cost of living increase. Active federal employees get a raise each year. It may be more than the COLA given to retirees or it may be less depending on the whims of Congress and the administration in power. (See Military Pay, Retiree Pay and Civilian Pay: What’s the Difference?)

Retirees get a fixed amount of an increase each year. Your retirement income does not go up because of a new promotion or a within-grade step increase. You will not be getting a performance bonus or a quality step increase as a result of your hard work. The human resources office will not be giving you a higher grade because your position has been reclassified. In short, what you get in your retirement check at the beginning of the year will not change.

The annual COLA is objective and a good feature of the federal retirement system. It is a feature that is lacking in many private sector retirement plans and a valuable benefit. But it isn’t perfect and not understanding how you may be impacted could have a big impact on your retirement future.

A number of retired readers have commented that the annual COLA increase did not cover the increasing cost of health insurance premiums. No doubt that is true and it can be the tip of the iceberg for a federal retiree. Here’s why.

The Department of Labor revealed recently that inflation was increasing early this year led by the biggest jump in medical costs in 15 years. And, in 2006, the cost of hospital and related services (such as nursing-home care and outpatient services) jumped by more than 6 percent.

Anyone who has shopped for a TV set, furniture or various household goods in recent years has noticed that prices are actually dropping for many items. Workers in China, Eastern Europe and other parts of the world work for wages that are much lower than those in the United States. Our manufacturing jobs are going overseas by the millions because it is cheaper and easier in many cases to build products overseas. The result is that we pay less for these new products than if we were building them within our own borders.

This has been a major factor in keeping our annual inflation rate at a low level. If you are in the market for a new widescreen TV in high definition, a luxury car from Japan or new furniture built in China, the drop in prices has been dramatic.

The problem is that if you are 70 and living on an income that is not increasing more than 2 or 3 percent a year, these falling prices may not have much impact on your true cost of living. Many retirees have paid off their mortgage and are living in a house that is fully paid for. Your focus is more likely to be on the cost of health care, prescrpition drugs, health insurance, property taxes, and groceries instead of buying a brand new 60 inch HDTV to celebrate your latest promotion.

In other words, your real cost of living is probably going up much higher than the COLA is going up.

One other item that retirees need to watch closely is the value of their savings and investments.

Whlie inflation has been relatively low, it will not stay low forever. No one can tell when it will go up again but it is likely to spike as a result of oil prices, political instability, increasing wages in overseas labor markets or a variety of other factors.

Retirees sometimes put all or most of their money in safe, fixed-income investments. Think, for example of the G fund in the TSP. It is safe and secure and goes up at about 4-5 percent a year. When prices go up, the value of the dollars in your possession goes down. Your stock prices may go up 10 percent or more in a year and will often go up much more than inflation. But cash, bonds and similar investments will not keep up with inflation.

In other words, when you retire, you may find that your real cost of living goes up more than for younger federal employees who are still working. Younger employees probably have a mortage that is paid off monthly at a fixed rate. Inflation actually works to the advantage of someone who is working, getting an annual pay increase and occasional promiotions and has a fixed-rate mortage. Their income may go up faster than the inflation rate and the mortage is being paid off with dollars that are worth less than when they were borrowed.

But a retiree may not be in that position. You may find that, while you are seeking safety and security with the money you socked away while working, the actual value of that money is decreasing as a result of inflation.

Many, probably most, federal retirees will have a great retirement and not have to worry about finances as a result of a generous retirement plan and good financial planning. But, before you leave a job you like and people you enjoy working with, be sure to honestly analyze your personal financial situation and your lifestyle preferences to make sure you have covered the real cost of retirement.


About the Author

Ralph Smith has several decades of experience working with federal human resources issues. He has written extensively on a full range of human resources topics in books and newsletters and is a co-founder of two companies and several newsletters on federal human resources. Follow Ralph on Twitter: @RalphSmith47