Everyone has their favorite moment of realizing the effects of inflation. Just five cents for a bottle of Coke? You’d be lucky to get that back as a bottle deposit today. A dime for a comic book? No amount of superhero time travel will bring that back. Less than a dollar for a gallon of gas? If you’re old enough to remember gas at those prices, then you’re old enough to be thinking about planning for retirement. And hopefully, at least a portion of your retirement income will be protected against inflation.

Over the past few decades, inflation rates in America have been relatively low and stable. Since 1999, the annual rate of price inflation has only been 2.2%.[1] As a result, the day to day effects of inflation have been relatively muted and not at the forefront of most American’s minds (there has been almost no change in the price of bananas in 20 years). Yet, the cumulative effect of inflation does build over time, even if the annual rates are relatively now. And for retirees who have fixed incomes that are not regularly adjusted for changes in the cost of living, even gradual inflation can profoundly erode retirement security.

How a Lack of COLAs Can Undermine the Security of Pensions

Consider the Texas Teachers Retirement System (TRS), which offers a guaranteed income-style pension benefit to around 400,000 retirees and active members. Most educators in Texas do not participate in Social Security, and the TRS pension benefit itself has no guaranteed cost-of-living adjustment (or COLA) built in. Instead, the legislature periodically approves a percentage increase in benefits on an ad hoc basis, or authorizes the payment of a 13th check.

As a result, some retired educators in Texas are seeing the value of their retirement income steadily eroding over time. Inflation rates in Texas between 1999 and 2018 mean that a $28,000 pension at the end of the 1990s is worth just $15,000 today.[2] Put another way, for a teacher who retired in 1999 to have seen the purchasing power of their pension keep up with local inflation, the annual payments today should be $52,000 — 46% higher. During the last 20 years, the Texas legislature authorized COLAs twice, meaning that pension first issued at the end of the 20th century has only grown to $32,000 today.

The National Overview

Nationally, around 75% of public pension plans offer an “automatic” COLA — that is, a cost-of-living adjustment that does not require a legislature or city council to approve the benefit adjustment.[3] Typically, these automatic COLAs are “pre-funded,” meaning actuaries account for adjustments to benefits after retirement, and build the costs of providing those adjustments into the annual normal cost payment that is divided between employers and members.

Other states require a pension board to approve a COLA based on the funded status of the pension plan, or inject politics directly into inflation protection by having legislatures approve the payment of COLA or 13th check on an irregular basis.

COLAs and Retirement Security

It is always difficult to forecast the future, but like death and taxes, we can expect the value of money to steadily change overtime. It is therefore important for any retirement plan to have some degree of inflation protection built in.

For guaranteed income plans like pensions, this will ideally mean a built-in COLA that is pre-funded along with the pension benefit itself:

  • The COLA could be issued annually or every other year,
  • The rate could be fixed or linked to local inflation, and/or
  • The benefit could even be adjustable based on investment performance or the funded ratio of the retirement system.

What is important is that the COLA not be issued on an ad hoc basis, prone to political whims and the need to come up with funding every year to ensure benefits get adjusted.

For guaranteed return (GR) plans or defined contribution (DC) plans, built in protection for inflation can be provided by requiring plans to offer access to convert their account balances into lifetime income:

  • Participants could be offered a range of annuities, deferred annuities, guaranteed minimum withdraw benefits, or other insurance-type products that would provide lifetime income with some periodic inflation adjustment,
  • Individual accounts could be enrolled in investment strategies that gradually shift a portion of retirement savings into an inflation protected asset, like TIPS or target-date funds include a glide path into inflation protected annuities, and/or
  • Retirement systems could offer to roll over a final account balance of a GR or DC plan into a companion pension fund that would provide annual, inflation adjusted income.

What is important is that the participants in the GR or DC plan be offered an easy, low fee, low risk way to take a portion of their retirement savings and convert it into inflation protected income.

COLAs and “Pension Reform”

One reason why COLAs are not as widely available on a pre-funded basis is that they are expensive. In fact, one way that states and cities have sought to reduce their costs of providing retirement benefits over the past decade is to reduce COLA benefits. At least 32 states have either lowered the COLA adjustment rate offered to retirees, reduced COLA rates that will be offered to future retirees, or removed access to COLAs all together for everyone.[4]

For states that are struggling to bring stability and sustainability to their pension funds, a temporary adjustment of COLA benefits as part of a package of other improvements may be a reasonable policy trade-off to preserve the core benefit for the long-term. However, COLA adjustments on their own as a way to make a pension plan cheaper are also undermining the ability to call that pension plan a retirement plan in the first place.

For policymakers, there are certainly a host of public policy trade-offs associated with providing retirement benefits, but it is important to understand the role that inflation plays in steadily eroding fixed levels of income, and how a lack of best practices with respect to COLAs will ultimately undermine retirement security.

For individuals, it may not be necessary that all retirement income is protected from inflation, but ensuring that at least a base amount of income has some inflation protection may be prudent to ensure a secure retirement.



[1] Source: Minneapolis Federal Reserve Bank. Technically, there is some debate over whether CPI today is fully capturing inflation, given the limits of how the methodology for inflation captures more advanced parts of the economy. Some economists suggest that price inflation is much higher than reported, as much as 6% annually in some years during the past decade. Other economists argue that the cost of goods relative to their quality of service has fallen more dramatically than captured in inflation measures, such as the relative costs of refrigerators or televisions. But no matter the formal accuracy of CPI’s current methodology, there are few credible forecasts that argue we are likely to see a deflationary future, meaning some form of inflation protection on retirement income is both prudent and warranted.

[2] Assuming an average of the inflation rates for the metropolitan statistical areas for Dallas-Fort Worth-Arlington, Houston, San Antonio, and Austin, as provided by the Bureau of Labor Statistics. Note that $28,366 is the average pension benefit paid to individuals who retired in FYE 1999 and had more than 25 years of service (see page 75 of the Teachers Retirement System of Texas Comprehensive Annual Financial Report FYE 1999).

[3] Source: NASRA

[4] Source: NASRA and authors’ own review of public plan provisions.