There is a tendency to regard a high cost-of-living adjustment (COLA) increase in retirement as a “good thing.” On the surface, it is easy to see where this rationale takes root. High COLAs equal more dollars in your pension check. When isn’t more dollars in your pension check a good thing?
Like most questions we get, it isn’t as simple as that.
First, it is probably best to explain where COLAs come from.
How COLAs Are Calculated
Every year the Department of Labor will release the Consumer Price Index for Urban Wage Earnings and Clerical Workers, better known as the CPI-W. The CPI-W will determine how much your federal pension will increase from one year to the next in retirement. This isn’t the same as any pay raises you may receive as a federal employee, that is a whole different allowance by the federal government.
When we speak of COLAs, we are talking about the annual percentage increase of your pension check. Some years it may be very high and other years it may be nothing. It just depends on how much inflation the economy is experiencing in any given year.
If you are a CSRS retiree, the good news is that your COLA increases will match the CPI-W, whatever it is. If you are a FERS retiree, the bad news is your COLAs will NOT match the CPI-W if the CPI-W that year is over 2%.
Briefly, as a FERS retiree, if the CPI-W is under 2%, your COLA will match the CPI-W, whatever it is. If the CPI-W is between 2-3%, you will get a flat 2% COLA increase in your pension. If the CPI-W is over 3%, you will get the CPI-W amount minus 1%.
Bottom line, every time the CPI-W is over 2%, you are receiving less COLA than what inflation was for that year. Illustration below:
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Inflation and Reduced “Buying Power”
As I’m sure you’ve heard, inflation has reached unprecedented levels that most Americans haven’t experienced for the last 25 years or so. It is fortunate that federal retirees receive annual COLA increases on their pension as this is a benefit that is uncommon with private sector pensions.
Yet as time wears on, and if our economy (even for a just a few years) sees higher than 2% inflation, your pension check will be losing more and more “buying power” as you progress through retirement. So, while you may get more “dollars” in your pension check during high inflation years, since you will not be matching the CPI-W on your COLA increases, the purchasing power that your pension check actually “provides” will greatly diminish over time.
Unfortunately for most FERS retirees in this predicament, their ability to earn more income in retirement is typically limited unless they take on another job after they leave federal service. Meaning, if we see several years of high inflation, it is very likely that you will need to augment your pension check with higher levels of your Thrift Savings Plan (TSP) assets than you may otherwise have been expecting just to make ends meet.
Tax Consequences
This unfortunate situation of higher inflation is further aggravated by the fact that your Traditional TSP assets are taxable as income upon liquidation. Since high inflation will also diminish the “buying power” of your TSP assets, you may be compelled to liquidate more of your TSP assets (and pay higher taxes) than you were planning to in retirement in order to just pay your monthly bills. This also says nothing of (likely) future tax increases that may be coming in ensuing years.
The Reality of High COLAs
Here’s the real consequence of these high COLAs and high inflation. Those two things go hand in hand. High inflation coupled with higher-than-expected taxes and TSP liquidations can lead to a downward spiral of your assets in retirement if you do not properly plan and prepared for it.
While getting more “dollars” in your pension check is not a bad thing per se, it is important to note that every time the CPI-W (as a FERS retiree) is over 2%, you’re losing buying power. Hence, you will likely be compelled to take more money out of your Traditional TSP to make ends meet, which will then increase your tax liability, and very likely put you in a position where your TSP may not last as long as you were expecting or needing in retirement.
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