The Leaflet: Reducing COLAs to Bring Pension Costs Down

Published September 1, 2017

Many states are providing to state workers automatic cost of living adjustments (COLAs), raising governments’ costs and forcing taxpayers to pay more for the same services. COLAs aren’t only applied to current workers earning government wages. For many pension plans, the benefits received are increased periodically to reflect inflation and the increased cost of living. While COLAs are common in the public sector workplace, in the private market, they are not automatic and only given when funds are available.

COLAs create problems for some states because in many pension systems, they are implemented automatically, regardless of the government’s ability to pay for them. As the number of retirees grows, a funding gap increases over time.

The rapidly increasing cost of state pensions and the market decline that occurred in the wake of the 2009-10 housing crash caused numerous states to reduce or eliminate their COLAs for many of their employees. Between 2009 and 2015, 29 states reduced COLAs. Seven of those states reduced COLAs for current employees and new hires. Sixteen states reduced COLAs only for current employees. Just five states reduced COLAs for new hires only.

Many of the states changing their COLA rules had a fixed guarantee of 2.5–3.5 percent compounded annually. This guarantee created a cost of living adjustment for workers and/or retirees regardless of what was happening to inflation, spurring unsustainable growth of state workers’ retirement benefits and making it nearly impossible for states to maintain a stable pension over the long term.

Lowering COLA can have a dramatic effect on pension liabilities, according to the Mercatus Center; a 1-percentage-point reduction in annual COLAs would reduce a plan’s accrued liability by approximately 10 percent.

There are several options states can pursue to help manage their COLAs. First, states can eliminate COLAs for all or a portion of retirees. New Jersey, Oklahoma, and Rhode Island have taken this route. New Jersey and Rhode Island suspended their COLAs in their pension plans until the plans are 80 percent funded. New Jersey would then require a committee to reactive COLAs, while Rhode Island would tie the COLA to investment performance in the future. Oklahoma took a different path. It required its COLAs to be prefunded at the time of enactment, making implementing a COLA policy difficult.

The second option for states is linking COLA increases to the Consumer Price Index (CPI). Several states have done this, and a smaller number have done so while also implementing a cap. When inflation is low, this method has a minimal effect on pension holders, but it also does little to help the basic pension funding problem. This method is also problematic because CPI is a flawed mechanism in its own right; it only measures the cost of private goods and services, not public goods, and it also lags behind real-world consumer trends.

Richard Ebeling argues CPI has an even more fundamental flaw: “[A]ny price index, whether the CPI or the PCE, are statistical constructions created by economists and statisticians that have very little to do with the actions and decisions of consumers and producers in the everyday affairs of market demand and supply.”If a state cannot move away from a CPI-linked COLA, it should either cap the COLA or keep it as low as possible.

Eliminating or reducing COLAs are a viable option for bringing down pension costs for states, because it is one of the few pension reforms that have consistently passed legal muster. According to the Center for Retirement Research (CRR), of the 17 states that have reduced COLAs, 12 have been challenged in court, and in the nine cases the courts have ruled on, only one cut was struck down. CRR says that for many courts, COLAs are not considered to be a contractual right and can be reduced by the state.

Taxpayers cannot afford for states to continue overpromising and underfunding their pension plans. States should consider reducing COLAs or ending automatic COLAs outright.

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