A cost of living adjustment is the increase in a wage or benefit that is applied on an annual or other regular basis that enables the wage or benefit to maintain the same level of purchasing power.
Why is a cost of living adjustment necessary?
In general everything becomes more expensive from year to year, this is known as inflation. While there are specific exceptions to this rule, such as consumer electronic products for example – these actually tend to become cheaper over time as mass production enables cost savings which are passed on to the consumer because of the competitive nature of the market, the general rule tends to overcome these exceptions.
This means that ordinary everyday costs rise on a gradual basis, a loaf of bread, a house (or rental payments), the fuel for your car, etc. will all be more expensive next year than this year assuming ordinary economic conditions.
A cost of living adjustment is not a raise per se, as it is designed to enable your wage to keep pace with inflation so that on a year-on-year basis your spending power remains the same, and you do not find yourself in a worse financial position than in a previous year.
Is a cost of living adjustment the same as an increase based on the current rate of inflation?
Not quite, if you receive a wage rise at the same level as the current rate of inflation (or the CPI for that matter) you will still be slightly worse off than the year before.
Why? Because the increase you receive will have tax deducted from it, and usually at the highest rate of tax that you pay. So a cost of living adjustment actually needs to be higher than the current rate of inflation in order for your purchasing power to keep pace with retail pricing.
Are there any other cost of living adjustments?
Yes, for people who have jobs that take them around the country or around the world – they may find that their employers pay temporary cost of living adjustments in order for their wages to retain the same purchasing power in a new location.
A common example of this would be for US Service people working in Japan, where local prices are substantially higher than in the US, depending on their pay grade, etc. a typical serviceman based in Japan will earn $300-$700 more than back home as a cost of living adjustment is paid during their time in Japan.
This allowance would be revoked when the employee returns to their normal place of work, or in the case of a serviceman when they are posted elsewhere.