Which is more meaningful for individuals - inflation or cost of living adjustment?

Question

I'm helping provide a neutral review of payscale changes at my office (as a non-financial person) and I'm not sure which metric to use when comparing pay raises to financial change. I understand the difference between COLA and inflation (or at least I think I do) but I'm not sure if one is more meaningful than another when it applies to individuals and salaries.

From what I've read, cost of living is basically inflation in prices of a subset of goods (is this the same as the consumer price index?) while "inflation" as used in headlines refers to the average price change of all goods.

Answer 1

The Consumer Price Index (CPI) is generally the the inflation number used in headlines. It's a rough estimation of the decrease of the value of a dollar related to certain consumer items. A cost of living adjustment (COLA) is applied to a structured payment in order to mitigate the effects of inflation. This structured payment could be salary, or annuity payments, or disability insurance payments, etc. COLA adjustments intend to keep someone's income stream the same, in real terms, despite the effects of inflation.

(I'm making these numbers up) As an example, 10 years ago, an apple cost $0.50; now an apple costs $0.75. That works out to 50% inflation. An apple is still an apple but now you need 50% more dollars to buy one. In order to mitigate that effect, you may receive periodic COLA increases to your salary, annuity or other stream of income. The idea is to maintain the value of your income from 10 years ago, in real terms.

Answer 2

I would give both numbers. You use the COLA to say that the government thinks that people on Social Security deserve that much of raise. Compare the percentage increase of your raise to that. "Our 5% raise is better than the 0% raise that the government is giving to Social Security recipients."

You use the CPI to adjust last year's salary to compare with the current year's salary. The amount that this year's salary is larger than the inflation-adjusted version of last year's salary is your real raise. "Our real raise is 2% over inflation."

Real raise = ((Salary this year * CPI from last year / (Salary last year * CPI from this year)) - 1) * 100%

or

Real raise = 100% * Nominal raise * CPI from last year / (Salary last year * CPI from this year)

Note that CPI data is released monthly. Try to pick the same month in both years. Ideally you'd pick the month that the raise takes effect, but if the raise is recent that data might not be available.

Be careful about this. If your company skipped raises in previous years, then what really matters is the starting salary before skipping and the current salary. So a 5% raise this year might have to cover inflation in this year and some number of previous years.

It's also worth noting that for individuals, what matters is their actual expenses relative to their actual raise. If someone's rent is going up 10%, telling them that CPI is only 1% is not going to help.