Cost of living refers to the amount of money required to maintain a standard of living, accounting for basics like housing, food, taxes and healthcare. Increases (or decreases) in the price of these necessities affect the cost of maintaining your lifestyle, and this in turn shapes how well your income will support you and your dependents.

How The Cost of Living Adjustment (COLA) Affects Income

Some forms of income, such as contracts, pensions and government benefits, increase along with the cost of living. This is known as a cost of living adjustment (COLA). The increases are based on a COL index and can change annually. If payment at your job is calibrated by this feature, it means that even if you don't get a raise, your purchasing power should stay the same as inflation increases.

Cost of Living and Salaries

Workers can use a COLA calculation to evaluate taxable salaries and income during negotiations with employers, or to compare how much a salary buys in different geographic locations.

If you are considering moving to another city to accept a new job, cost of living indexes can be used as an indicator of how suitable a salary offer is relative to your current income and standard of living. (See Know Cost of Living B4 Taking A Relocation Package.) Housing, food, and taxes vary between states and even regions. Cities, regions and states with a lower cost of living usually mean your income will go further – you'll have more money left over after you pay for the basics. Areas with higher cost of living figures usually mean that workers have less disposable income, or money in their bank accounts, after paying for the basics and need higher incomes to live as well as they would in a less costly region. The Council for Community and Economic Research has a handy cost of living comparison tool on its website.

COLA and Retirement Income

Over time, inflation and increasing prices for goods and services can seriously erode investment income and pension benefits for retirees living on a fixed income. If monthly income remains relatively the same while basic costs – food, shelter, healthcare, taxes – increase, retirees who enjoyed comfortable early retirements may find themselves pinching pennies as time goes on. This is because their purchasing power has been eaten away by inflation.

Some forms of retirement fixed income do increase with the cost of living, due to a COLA. Income derived from COLA-based pensions, COLA-indexed pensions and government benefits for retirees, such as Social Security, will retain their purchasing power as inflation increases,as long as their COLA formula is sufficiently generous.

COLA vs CPI – Do They Affect Income The Same Way?

CPI is the acronym for the Consumer Price Index. The media's use of CPI and COLA interchangeably may be confusing. The CPI represents the cost of an imaginary basket of basic goods and services. It is used as a basis for calculating cost of living indexes and COLAs. While both are meant to show changes in the prices of the basic necessities of goods and services over time, cost of living indexes also factor in changes in government and environmental conditions that may affect consumers.

Using the Term "COLA"

Sometimes the term COLA is used to describe salary "adjustments" or allowances for workers, including military personnel temporarily relocated to another city, region or country. Though the idea is to compensate workers for a change in their welfare resulting from moving to a different location, the adjustment or bonus pay may be more accurately described as a per diem allowance to be used for a temporary and specific cost, such as a higher rent. The extra payment does not continue when the temporary assignment ends, whereas a true COLA for a permanent salary remains in place.

The Bottom Line

The phrase "cost of living" refers to a measure of the cost of sustaining a certain standard of living. Cost of living indexes can be used to compare salaries across different areas. A cost of living adjustment (COLA) calculation may be used to increase certain kinds of income such as contracts, pensions or government benefits so that they can keep up with increasing basic living costs, as represented by the CPI.