By Roger Wohlner, Expert Contributor
What Is a Cost of Living Rider?
Cost of living adjustment, or COLA, riders are an option for annuity contract holders who want to ensure that their annual payments are adjusted upward each year to help offset the impact of inflation on their payments.
Cost of living riders adjust the amount of the annuity payments each year. Depending upon the contract, the rider can be added at the time you initially open the contract or at a later date.
It’s important to weigh the rider’s benefits against its cost, which typically is in the form of a reduced initial benefit. When you add a cost of living rider, the insurance company will lower the amount of the monthly benefit and then calculate the annual cost of living adjustment off of that lower base amount.
You will want to view the annuity contract in the context of your overall retirement income plan to see if the rider is right for you.
How Is the Cost of Living Adjustment Calculated?
There are generally two main methods of calculating the cost of living increase for an annuity rider. Payments may increase either by a level or set percentage or based on the annual increases in the Consumer Price Index.
Level Percentage Increase
A cost of living adjustment or COLA rider based on a level percentage increase means that the payment will increase by a level or set percentage each year. Generally, this percentage will range from 1% to 6% annually. The level percentage increase can be calculated either on a simple or compound basis.
With a level percentage increase calculated on a simple basis, your annuity payments will rise by the annual percentage increase you’ve chosen regardless of what inflation does. For example, if the annual percentage increase is 4%, your payments for the next year will increase by that amount. If you receive monthly payments, this increase will be reflected in those payments.
When the level percentage increase is calculated on a compound basis, the annual percentage increase is based upon the most recent year’s value. The compound method is the most common one. It is analogous to the idea of compound interest on a savings account or similar vehicle. This method will yield a larger increase than the simple version of this option.
The level percentage increase tends to be a better deal for contract holders during periods of moderate to low inflation. During periods of high inflation where the inflation exceeds the amount of the level percentage increase, contract holders can actually lose purchasing power each year under these conditions.
This type of COLA rider is based on the annual increases in the Consumer Price Index, or CPI. The CPI is what is generally quoted when we hear about the level of general price inflation in the news. While the CPI isn’t perfect — for example, health care and prescription medications tend to rise faster in price than the CPI — it is a good indicator of the general rate of inflation in the economy.
During times of low inflation, a CPI-based adjustment will result in relatively low annual increases.
Considerations in Deciding Whether a Cost of Living Rider Is Right for You
There are several factors to consider when deciding whether or not to add a cost of living rider to your annuity. Key considerations include inflation, the cost of the rider and your other retirement assets.
Inflation is perhaps the number one enemy of retirees. Even a seemingly small level of inflation in the 2% to 3% range can erode a retiree’s purchasing power in a relatively short period of time. A COLA rider can help offset the ravages of inflation on your annuity payments.
Cost of the Rider
While inflation protection is certainly important, the benefits must be weighed against the cost of the rider. There is no payment made to the insurance company. Rather the company reduces the amount of your initial payment after the rider takes effect.
Make no mistake the reduction in the initial benefit amount is a cost. In deciding whether or not to go with the rider, it’s critical to understand the amount of the reduction in the payment.
With this reduction you will want to see how long it will take for the payments with the COLA rider to meet and exceed the level of your payments prior to taking the rider. Ask your advisor to calculate the payments over several time periods both ways. With a CPI-based rider, some assumptions may need to be made. From this analysis, you will get an idea if the COLA rider is a good deal for you.
Other Retirement Assets
Consider your overall retirement income plan. In other words: What other types of investment accounts or streams of payments do you have to support your retirement lifestyle? How are these various sources of income set to deal with the impact of inflation in retirement?
Investment accounts might include IRAs and other retirement accounts, as well as taxable investment accounts. Find out how this money is invested. Is a portion invested in stocks, for example?
Streams of payments generally include Social Security, and in some cases, a pension from an employer. Social Security does have a COLA increase in most years, though some may question if these increases actually keep up with inflation. A pension from a private sector employer typically will not have a COLA increase; public sector pensions often do.
About the Author
Roger Wohlner is a freelance financial writer with more than 20 years of experience as a financial advisor. He received his MBA from Marquette University and his bachelor’s degree with an emphasis in Finance from the University of Wisconsin-Oshkosh. He has passed the Series 65 – Uniform Investment Adviser Law Examination, and his work has been featured on respected sites, including U.S. News & World Report and Yahoo Finance.