Inflation is an economic reality that affects people worldwide, causing prices to rise and eroding the purchasing power of money over time. To keep up with inflation, many employers offer Cost of Living Adjustments (COLAs) to their employees’ salaries or pensions. However, there is such a thing called a “COLA Trap” if you don’t understand how it works.
A COLA is an increase in salary or pension that is tied to the rate of inflation, Investopedia explained. When inflation rises, a COLA will increase the employee’s income, so that they can maintain the same standard of living.
The problem with a COLA is that it’s based on a measure of inflation, which is often flawed and can lead to underestimating the true cost of living.
This photo representation shows US Dollar Bills as military retirees gave a warning about the ‘Cola trap’ that could cost you thousands. (Photo by Alexander Gray on Unsplash)
COLA Trap Explained
The COLA trap is a term used to describe the situation where an individual’s income, which is tied to COLA, fails to keep up with the actual cost of living.
Investopedia said the COLA trap can occur when the rate of inflation outpaces the cost-of-living adjustments to income or benefits that are intended to keep pace with inflation.”
For example, if the COLA is based on the Consumer Price Index (CPI), and the CPI fails to accurately reflect the true cost of living, the COLA could be lower than what is needed to keep up with inflation. This means that an individual’s income may not be sufficient to maintain their standard of living, leading to financial difficulties.
Economic Policy Institute explained that the CPI “has long been criticized for its limitations, and recent research has shown that the CPI likely underestimates the rate of inflation for some populations, such as seniors and low-income families.”
Therefore, it’s important to be aware of the potential limitations of a COLA and to take steps to avoid falling into the COLA trap, such as those outlined in the previous answer.
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How to Avoid Losing $100s
According to The US Sun, pensioners have made an additional $87 for every $1,000 in monthly pension payments.
Douglas Fowler, an Air Force colonel, has explained how veterans may avoid losing out and has issued a warning about the infamous COLA trap.
He said that the COLA and military retirement compensation are determined by the month and year that a person retires.
In a paper, Fowler disclosed that Lt. Cols. Johnny Late and Jane Early enlisted in the Air Force simultaneously and served for 20 years.
But when they earned their first COLA, Late retired a month after Early and received a $1,000-a-year lower pension.
This is so because the first COLA is determined by several variables, including the month when an American retires.
The first COLA contrasts the rate of inflation between the first and second quarters of the same year.
The difference between the third quarter of the year and the quarter just before retirement will be computed for retirees.
He advised military people to take their retirement in the last three months of the year.
Additionally, Americans who work longer will earn more in retirement.
How to Avoid Trap
In a Military.com report, Fowler formulated a few tips to avoid the COLA Trap and avoid losing more money in retirement.
Retire in the last month of the fiscal quarter. Retiring in the last month of a fiscal quarter is a good option as it offers the same initial COLA as retiring in the first month but also includes the extra pay for longer service.
Don’t retire in September. September is the worst month to retire, while March 1 retirement date is the best option for a good initial COLA, as it has provided the largest difference between two-quarters of average inflation historically.
Avoid Retiring on July 1. Retiring on July 1 should be avoided as it can result in a bad deal for retirees. By following these guidelines, retirees can select a retirement date that works best for their schedule and provides the best paycheck.
By following these guidelines, retirees can select a retirement date that works best for their schedule and provides the best paycheck.
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