With high inflation comes inevitable talk of COLAs, or cost-of-living adjustments. A COLA is a pay increase given to employees based on how much it costs to pay for basic needs like housing, groceries, and utilities.
The popularity of COLA pay in the US dates back to the 1970s. That’s when the US government began adjusting Social Security payouts with automatic COLAs.
Social Security benefits are an otherwise fixed income source—there aren’t any raises or bonuses. Because of this, COLAs make sense.
But it’s really hard to make a case that private companies should use COLAs, too. There are simpler ways than COLA payments to accomplish the same objective. And they come with much better results and far less headaches.
What COLA Pay Is Supposed To Do
COLA pay is supposed to help employees afford to live in high cost-of-living areas. Let’s say an employer has offices in Texas but sometimes requires employees to live in California.
There’s a big difference in cost of living between the two states.
Here’s what life in Texas looked like in late 2023:
- Average gas price: $2.97
- Average price of a gallon of milk: $2.81
- Average monthly rent for a 2-bedroom unit: $907
Now let’s look at California during the same timeframe:
- Average gas price: $5.29
- Average price of a gallon of milk: $3.50
- Average monthly rent for a 2-bedroom unit: $2,405
The employer could give the California-bound employee a COLA to help them pay for basic needs while they’re required to live outside of Texas.
Honestly, in this scenario, COLAs kind of make sense. But if everyone lives and works in Texas, are COLAs really warranted?
How do companies figure out how much to pay in COLAs, anyway?
Many companies use the Consumer Price Index, or CPI.
The CPI is a group of indexes that calculates the average price change over time for common consumer goods. These include things like groceries, transportation costs, and rent payments. The CPI fluctuates every month and helps inform the inflation rate.
If the cost of living in the United States rises 3.7% in one year, a company could then decide to give all employees a 3.7% COLA. So if an employee made $50,000 in one year, they’d get $1,850 more per year, or $154.16 extra each month.
But if the cost of living jumps to 9.1%, as it did in the US in post-pandemic years, that’s a much bigger COLA. We’re talking $4,550 more per year for a person who makes an annual salary of $50,000.
If a company also wants to give out performance-based raises, the COLA complicates things. Especially since the CPI changes every month. During which month should you implement COLAs? May, when the CPI is just 1.5%, or August, when it rises to 4.0%?
Or what if you implement a COLA and then inflation spikes—or diminishes—immediately after?
COLAs usually add more complexities and headaches to your payroll department than they’re worth. Using a COLA to help employees afford basic necessities is a great theory. But in practice? It’s a mess.
Even the best payroll software services will have to work overtime to clean up what COLAs leave behind.
COLA Pay Is a Missed Opportunity
The root issue with COLA pay is that it becomes an expectation. Essentially, you are inflating salaries every year without any incentive for employees to improve or grow.
Instead of giving raises for reasons that have nothing to do with an employee’s performance, use performance raises and merit bonuses to reward good employees.
Many companies use these reward systems to motivate employees.
To enact a strong performance raise policy, you should have a set of expectations for your employees to meet. If employees meet the expectations, they receive a raise.
The last thing you want to do is hand out raises haphazardly without using a method you’ve outlined in your employee handbook.
Instead, create performance review rubrics for each level within a job family. Have your managers assess employees based on the rubric. You can do this annually or bi-annually—whatever fits your payroll budget and schedule best.
Let’s say your rubric has five performance levels for each skill: Poor, Needs Improvement, Acceptable, Good, and Excellent.
Now, we’ll say there are five skills you’re evaluating. Things like punctuality, productivity, and initiative. You could build a system that says if an employee meets the Acceptable criteria for at least four out of the five skills, they get a 3% raise.
If they meet the Good criteria for at least four of the five skills, they get a 4% raise. And if they meet the Excellent criteria for four out of five skills, they get a 5% raise.
All of this means that if the employee gets too many Poor or Needs Improvement scores, there’s no raise. Instead, your management team can meet with the employee to find out how they can support that person’s growth.
Meaningful raises with a clear path upward are a better way to counteract inflation and keep employees fulfilled.
There’s no such performance upside for COLA pay—just extra costs for you. Why set yourself up for those traps?
Benchmarking Works Better Than COLA Pay
The only real way to truly adjust for the cost of living is to do compensation benchmarking. In other words, you look at salaries in your industry and see how the salaries you’re paying compare.
With benchmarking, you can set salary bands that determine the low and high end of what you’ll pay for a specific position. You’ll be able to relax knowing that the salary range is on pace with the rest of the market.
Honestly, marking your salaries to the market is the only way to truly stay on top of inflation. Some jobs and markets outpace inflation by a lot. Even generous COLAs won’t matter for in-demand roles.
Benchmarking isn’t a perfect science, but it will get you closer to the mark than COLA payments. Refreshing your salary benchmarks each year will keep them competitive and tied to reality.
This is the only way to keep pace with the unique demands of your specific industry and keep talented people around for a long time.