Episode 68 – Understanding COLAs and the CPI connection
Episode transcript:
[music intro]
Jenny
Welcome back to Fund Your Future with DRS. Today we’re talking about everyone’s favorite subject COLAs, which stands for Cost of Living Adjustment. So basically at the end of each July, most retirees receive a Cost of Living Adjustment on their pension and the COLA can increase up to 3% each year. And it’s based on the Consumer Price Index for Urban Workers, or CPI U in the greater Seattle area. So, to learn a little bit more about this CPI-U we’ve invited Matt Smith, the state actuary, back to the podcast. Welcome, Matt!
Matt
Thank you. Great to be here.
Seth
So Matt, state law ties the pension for COLAs to the Seattle CPI-U as Jenny mentioned. And first could you just explain to our listeners what the consumer price index is, what it’s trying to measure and how it’s calculated?
Matt
Yeah, I’d be happy to. I don’t consider myself to be an expert on the CPI, but I you know, I’ve worked with it quite a bit over the years, as you mentioned, you know, directly tied to our retirement system. So, I definitely can share what I know, what I’ve learned over the years. At the highest level, you know, it’s really just measuring price inflation. How is the price of, you know, various goods that we buy as consumers in a particular region? How is it changing from one period to another?
Jenny
Yeah, and as we mentioned before, most of our retirees will see a COLA increase on the pension payment that they receive at the end of July. How does CPI determine the amount of that COLA.
Matt
Yeah. And going back to the you know, the first question, you know this price inflation. You know the Bureau of Labor Statistics will calculate this index. Think of it as a basket of goods that folks are assumed to buy. Things like the cost of housing, you know, the cost of transportation, food and beverages, health care. But the BLS Bureau of Labor Statistics will go out periodically and do surveys for consumers in various regions.
And come up with sort of like what they assume basket of goods that we buy and then sort of document what’s the average price of those things, assuming that you buy those things at those assumed proportions, and then look at that same basket of goods a month later, six months later, a year later, and measure how much has the price increased.
That would be your price inflation. And in our state, the calculation is done on an annual basis. It’s looking at change in that basket of goods on a calendar year basis. For the retirees that just received a COLA on July 1st in 2025. It would have looked at the change in prices from calendar year 23 to the end of calendar year 24.
So, it’s not necessarily the inflation you’re experiencing right now in this moment. Think of it as more of a calendar year impact in the change in prices.
Seth
I really appreciate that, Matt. And I think for a lot of our listeners and especially our younger listeners, inflation hasn’t been something that we ever dealt with or lived with or thought much about. And I know at DRS over the last few years, we’ve had lots and lots of more questions about COLAs and about inflation, and so trying to get a little bit better understanding of the way that CPI is calculated, I think will be helpful for everyone.
One of the things I wanted to mention, I recently read a book called Who is Government? It had profiled a bunch of public workers and the great work they’ve done and profiled 10 or 12 individuals, but one of the profiles was of the Bureau of Labor Statistics and the calculation of CPI. And why it’s important because, as you mentioned, understanding how prices change over time in some sort of consistent scientific way is really helpful to think about how I’m budgeting things, how I’m going to spend my money.
And I think it’s important to recognize that it’s not a perfect calculation for each individual. And I’m hoping you can expand on this a little bit, because you were talking about this basket of goods. And one of the things when I think about inflation, I think back to Covid in 2020, and people were talking about how much their budget changed because they were spending money on different things.
They were maybe driving less. And so, the cost of gas wasn’t impacting their budget as much. And can you just explain a little bit about how a retiree might experience inflation different than how the Bureau of Labor Statistics is calculating our CPI for the COLA adjustment?
Matt
Happy to you. I think it’s a great observation. The first one that comes to my mind would be the, you know, the basket of goods, right? So, the CPI-U or the CPI-W you know, the more technical long term your name is, you know like urban wage earners or clerical workers. So, it it’s measuring inflation on the, the goods that workers are consuming or buying.
It’s not based on retirees. And retirees are most likely you know buying different goods. Their proportion of you know, their basket, if you will, is going to be made up of different things, could be higher health care costs, than a worker. So that’s probably step one is it’s not measuring the inflation that a retiree is likely experiencing.
And it wasn’t necessarily a policy choice. I mean, that was just the way it was defined when the plan was created, some of them back in the 1930s and the 1940s, and our plans 2 and 3 in the 1970s. I think there’s only an experimental CPI that’s based on retirees. So, it’s not like there’s something out there that we’re not using.
It just really wasn’t set up that way. The other thing that comes to mind would be I mentioned earlier that it’s based on this basket of goods, but particular to a region. So, our plans are typically set to the Seattle, Tacoma, Bellevue region, where a large proportion of our state workers probably reside, but not all of them. Retirees, as you know, as the plan administrator.
They all don’t live in Washington State. So long live outside Washington state and some live in other countries. So, it’s the inflation that they’re experiencing could be significantly different depending on where they live.
Seth
I really appreciate that point about retirees spending money differently than the average worker and thinking about how inflation impacts people differently. I think our office is definitely heard from people and not understanding that the CPI that’s being used is that annual adjustment. And so, as you said, the COLA that people are going to get in 2025 is based off inflation from 23 and 24.
The difference between those two years and oftentimes what is reported in the news is month over month inflation or year over year inflation; but it’s April to April and not, you know, year to year end. So, there are all sorts of different numbers out there. And I think it can make people a little bit distrustful of the process and understanding that really, this is just the best measurement we have.
And this is as you said, one measurement that was selected 30, 40 years ago for our plans. And it is a consistent measure. And so hopefully this conversation helps build a little bit more trust in the process. Is there anything else you want people to think about with COLAs, or maybe something that comes up in your office with the CPI that might be beneficial for folks to know?
Matt
I might just expand on one of the points you mentioned earlier. I think the timing is a huge, huge thing in the measurement period. We’ve definitely observed more attention to inflation and inflation being a lot higher than it has been maybe the prior, you know, 20 years. And you’ll like you mentioned, you’ll hear reports about particular areas of inflation that just really jump up, you know, like avian flu and the price of eggs.
I think we all can remember, you know, a news story for quite a while. It seems like it’s gone away. Didn’t persist for an entire year. You might even eat eggs, right? Another thing that maybe works to a retiree’s advantage in this space is the CPI measurements don’t frequently get updated for substitutions. So, we as consumers will freely substitute goods.
And maybe we move away from something that we are experiencing a bit of price inflation. The BLS does update their surveys, does update the basket of goods, but not that frequently. So yeah, there’s a lot of pros and cons to it. But I think you hit on a couple really key points too, is that this is something defined in statute, right?
That this is something the legislature implemented when the plans were first initiated, not a policy decision or a DRS decision where you decide appropriate CPI or whether it’s tracking well or not. Well, it really is, you know, the contract provision, if you will, of our plans. That was established when they first were created. And other than the BLS making some changes in how they perform their measurements, I’m not aware of any CPI. That has been statutorily changed for our plans.
Jenny
And Matt, you kind of mentioned this earlier about how it’s based on what workers are consuming, not exactly what retirees are consuming. And has there been any sort of discussion about changing those measurements?
Matt
I haven’t heard any discussions that the, you know, the Washington state level in terms of the policy. The only thing I’m aware of is that, as I mentioned earlier, the Bureau of Labor Statistics does have this, what they call an experimental CPI, where they do track, a different basket of goods for retirees. Assuming they did that for a reason and to compare it to a consumer based or worker based CPIs.
But I’ve never seen them do anything with it or that lead to any, any policy changes.
Jenny
Gotcha.
Seth
I want to thank you for joining us, but I also did want to help our listeners realize that COLAs on pension plans aren’t always common across the country, and this is a really beneficial feature for our plans. Our for our plans, 2s and 3s that have, this COLA based on, the inflation index for the area. I’m curious if you have any thoughts on that, that you would like to share with the audience as well?
Matt
I think it’s a great observation. You know, I don’t have exact numbers, you know, in terms of like how many public plans have them or don’t have them. But, you know, a fair amount of them don’t for sure. They manage them on more of an ad hoc basis, meaning that, you know, maybe here or there they will add those on, they can be expensive if it’s something that you’re adding at the end of a plan’s life.
From a plan design perspective, this is this is something you, from an actuaries perspective, that you really want to be thinking of early on of the plan design. You want to be funding for it. You know, modeling future inflation makes it a lot more affordable than having to manage it on an ad hoc basis once someone’s already retired.
So, you know, in our state, we were fortunate with our plans 2s, 3s to have had those in place from the very beginning for the Plans 1, they weren’t part of the original plan design (Plans 1 public employees and teachers). And that’s led to, you know, an ongoing challenge. A challenge for those retirees, a challenge for the legislature to find a way to be able to afford adding those COLAs for retirees. And a plan designed where it really wasn’t considered something that was part of the original plan design.
Seth
I gotcha great, thanks for talking with us about COLAs Matt.
[music outro]
Disclaimer
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