How Cost of Living Raises Work

The level of inflation has varied widely and so have cost of living raises. Regular Social Security cost-of-living adjustments (COLAs) began in 1975 when inflation was running high. The first COLA was 8 percent. The raise reached a high of 14.3 percent in 1980. During the 1990s, lower inflation led to more modest increases, which averaged 2 to 3 percent a year. While inflation has never returned to 1970s levels, a spike in energy prices in 2008 meant a 5.8 percent increase that year [source: Social Security Online/Historical].

So what happens when there's no inflation? What if the CPI actually drops, a trend known as deflation? Most cost-of-living raises only go one way. There is no pay cut in the case of deflation. The recession did reduce inflation to zero in 2009 -- in fact the CPI went down slightly over 2008. That made 2009 the first year when Social Security recipients received no COLA [source: Practical Money Skills].

In the private sector, contracts with cost-of-living raises have been disappearing over the past several decades. The reasons include the low level of annual inflation, the waning power of unions, and employees' focus on other benefits, like health insurance.

The pay raises companies offer today are more likely to depend on productivity and profitability than on the level of inflation. Employers want to avoid automatic pay increases. They would rather give a one-time bonus to counteract a year of higher inflation than be stuck with permanent increases.

Public workers are more likely to be covered by cost-of-living raises. Some state laws require cost-of-living raises as part of state employee contracts. This has led to more-rapid wage increases for public workers than for employees of private companies. From 1998 to 2008 public wages grew almost 29 percent; private wages increased only 19 percent [source: Gillespie].

In the next section, you'll read about how frequently cost of living raises tend to be given.