Making Cost of Living Adjustments to Public Pensions During the Coronavirus Pandemic and Beyond
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Making Cost of Living Adjustments to Public Pensions During the Coronavirus Pandemic and Beyond

Cost of living adjustments that move with actual measurements of inflation are more appropriate than fixed-rate increases—especially in a year like 2020.

When defined benefit pensions were created in the early 20th century, annual price inflation was typically low and not considered in the benefit design. Inflation gathered steam in the 1960s and reached double digits during the 1970s, rapidly eroding the value of some fixed income streams, like public pension retirement benefits.

Cost of living adjustments (COLAs) were implemented to protect retirees from losing purchasing power due to price inflation. But, in some states, the cost of living adjustments have become disconnected from their original objective— an issue currently highlighted by the emergence of price deflation this spring.

Like public employee pensions, the federal Social Security program traditionally provided fixed monthly payments after retirement. As inflation grew, Congress passed a series of one-time benefit increases, but eventually decided to make the adjustments automatic. Starting in 1975, Social Security benefits have been increased annually by the rate of growth in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

Most large public employee defined benefit pension plans also adopted cost of living adjustments. But not all COLAs are equal. A recent issue brief from the National Association of State Retirement Administrators (NASRA) surveyed COLA provisions across state pension systems, finding a wide array of practices. Many state plans adjust benefits based on CPI changes, while some offer constant adjustments each year regardless of changes in year-over-year inflation. In both Arkansas and Mississippi, for example, retirees receive a 3 percent annual increase irrespective of the rate of price inflation.

Since the early 1980s, the economy has seen a general trend toward lower inflation, albeit with occasional spikes. In 2020, the coronavirus pandemic has reduced aggregate demand, triggering price declines for many goods and services.

In April, CPI -W declined 0.7 percent. In May, it declined an additional 0.1 percent and was 0.1 percent below its level one year earlier. The more widely followed Consumer Price Index for All Urban Consumers (CPI-U) declined by 0.8 percent in April, 0.1 percent in May, and was 0.1 percent above its year-ago level.

At this point, inflation is expected to remain low for the rest of the year. Recently, Kiplinger forecast, “The inflation rate should end the year at 0.3 percent, far below last year’s 2.3 percent. Core inflation, which excludes the costs of food and energy, will continue to run higher than the headline rate, at about 1.1 percent over the course of this year.”

Over the long-term, inflation rates will be subject to countervailing forces. If we are entering a prolonged recession, aggregate demand will remain muted—putting downward pressure on prices. Additionally, the extended shelter-in-place orders aimed at fighting the coronavirus pandemic, from which cities and states are now mostly emerging from may have broken consumption habits. For example, consumers now accustomed to staying at home may be less likely to venture out for their regular retail shopping, especially if they remain worried about catching the coronavirus.

On the other hand, the Federal Reserve has greatly increased the money supply in response to the COVID-19 crisis. Between February and April, the Fed’s M1 measure of money supply, which includes cash and checking accounts, increased by 20 percent from $4 trillion to $4.8 trillion on a seasonally-adjusted basis.

Potentially, this could presage a sharp rebound in consumer price inflation as the economy improves. As Nobel Prize-winning economist Milton Friedman famously said:  “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”

But during the 2010s, the money supply increased much faster than output with relatively little inflation.  While M1 increased by a total of 132 percent in the 10-year period ending December 2019, real gross domestic product (GDP) grew by only 25 percent and CPI-U rose only 19 percent. A lot of the new money appears to be finding its way into equities, a trend that appears to be continuing given the rapid rebound we saw in stock prices during May.

Finally, it is worth noting that retirees may experience different cost of living changes than those affecting the working public. For example, the homeownership rate among older Americans is much higher than that of younger Americans, which suggests that retirees are generally more protected from the rapid rent increases that many cities have seen in recent years. On the other hand, some retirees have greater exposure to increases in health care costs, but many are insulated by Medicare and employer-provided retiree health benefits.

As the NASRA survey shows, some state retirement systems provide COLAs that are a percentage of the change in consumer prices.  For example, many Missouri retirees receive COLAs equal to 80 percent of the increase in CPI.

Given the power of compounding, annual adjustments can greatly increase the cost of pension benefits over time, limited COLA benefits may prove more sustainable in the long run. An individual retiring in 2020 with a $100,000 annual pension and a 3 percent fixed COLA would receive $180,611 in 2040. On the other hand, if the same individual received 80 percent of CPI and if CPI remains at the Federal Reserve’s 2 percent target, the benefit will grow to only $137,364 in 2040. This lower inflation-adjusted future benefit translates into lower unfunded liabilities today – all other elements being equal.

Although the trajectory of future price inflation and its impact on public sector retirees is not certain, we can be sure that the impact of inflation on retirees will vary over time. Consequently, cost of living adjustments that vary each year and move with actual measurements of inflation seem more appropriate than fixed rate increases, especially in a year like 2020 which will see little or no price inflation. Finally, whatever cost of living approach a plan sponsor uses, the public pension plan should have funding mechanisms that prevent inflation adjustments from increasing unfunded liabilities.

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