Best practices for cost-of-living adjustment designs in public pension systems

Gold Standard in Public Retirement System Design Series

Inflation’s impact on the purchasing power of retirement benefits and savings needs to be managed when designing and funding effective retirement plans. Periods of high inflation show how important properly designing inflation protection measures is in public sector defined benefit (DB) pension plans.

These plans have addressed this dilemma in different ways over the years with varying degrees of effectiveness. More recently, public sector pension reform efforts have often significantly changed how cost-of-living adjustment (COLA) and post-retirement benefit increase (PBI) features are designed and funded.

This brief focuses on how state and local government defined benefit public employee retirement systems have used cost-of-living adjustment benefit features to address inflation’s risk to retirement security. It also provides a set of best practices to help guide policymakers and stakeholders in designing and funding inflation protection design elements for their defined benefit pension plans.

Executive Summary

Cost-of-living-adjustment (COLA) benefits are a common feature of many public employee retirement systems used to provide a level of protection against loss of purchasing power in retirement resulting from inflation. Public defined benefit (DB) pension plans use a wide variety of COLA benefit designs and funding methods that have led to a mixed bag of outcomes for retirees and have often exacerbated existing underfunding problems.

The principal problem with most COLA benefit provisions is failing to treat it as one of the plan’s core benefit objectives and to prefund it the same way as the primary retirement benefit. Instead, too many plan sponsors apply ad hoc COLAs unevenly. In addition, there is an issue of inconsistent timing. Moreover, not enough thought is given to how actual inflation impacts those who receive the increase. And finally, too little consideration is given to how the increase impacts the total program’s long-term funding.

This brief identifies several proposed best practices to guide public plan sponsors to a more coherent and financially sustainable COLA benefit design and funding for their pension systems. The best practices include:

• Best Practice #1 – Public pension plan sponsors should create a formal cost-of-living adjustment benefit policy that is an integral part of the overall retirement plan objectives. This provides clarity for the retirees, sets expectations properly, and provides guardrails for future policymakers when faced with changing circumstances.
• Best Practice #2 – The COLA benefit design should clearly identify 1) who is eligible for the COLA, 2) what benefit the COLA applies to, and 3) when it is payable. This is necessary to force recognition of the reality that the plan cannot and should not provide unlimited inflation protection for all participants.
• Best Practice #3 – The COLA amount should reflect an objective inflation benchmark. This helps provide a more predictable amount of inflation protection and more equitable distribution of benefits for similarly situated retirees.
• Best Practice #4 –The COLA Benefit amount should be consistent, predictable, and clearly communicated to the retirees. Retirees need to have a firm understanding of what COLA benefits will or will not be provided to set expectations and to allow them to manage their retirement assets and income more effectively.
• Best Practice #5 – The COLA benefit amount should be limited. This recognizes that inflation varies over time and that the COLA benefit design distinguishes between “normal” inflation and periods of high inflation that are more difficult to predict. Establishing limits or caps on the COLA benefit is needed to allow more sustainable funding approaches.
• Best Practice #6 – COLA costs should be pre-funded as part of the overall normal cost of the retirement plan. Pre-funding of COLA benefits is essential to ensure the consistent delivery of inflation protection to retirees and to avoid the creation of unfunded liabilities. It also avoids the creation of complicated and unpredictable COLA funding schemes, such as investment gain sharing or actuarial funding margin reserve allocations.
• Best Practice #7 – COLA benefits should be subject to change for future accruals and new employees. COLA benefits should be subject to adjustment for future accruals for current active employees and for new hires to create benefit design and funding flexibility under changing circumstances.
• Best Practice #8 – Plan sponsors must stop making the same mistakes. This recognizes that it is important to break the cycle of suboptimal COLA practices.
• Best Practice #9 – New practices must refrain from trying to fix all past inflation. Not all past inflation has to be fixed. This recognizes that there are limited public funding resources, and prioritization among competing demands for the public treasury is necessary.

Cost-of-living adjustment design and funding are complicated at many levels. The need for some inflation protection for public pension retirees is clear, but resources to provide protection are limited. This means public pension plan sponsors should carefully craft COLA benefit and funding policies that help maintain financial security for retirees but do so in a financially prudent and risk-managed basis.

Following the best practices outlined in this paper should provide some important guardrails for designing effective COLA benefits, which will help plan sponsors as they strive to strike the proper balance between cost, risk, and benefit in a way that works for both employees and employers.

Full Brief — Best Practices for Cost-of-Living Adjustment (COLA) Designs in Public Pension Systems

This policy brief is part of the “Gold Standard in Public Retirement System Design Series,” which reviews the best practices of state-level public pensions and provides a design framework for states that are struggling under the burden of post-employment benefit debt.