Including a cost of living adjustment (COLA) in a pension present value calculation typically drives the value up 20 to 35 percent. Surprisingly, it is a poorly although widely litigated issue. The impact of COLA—yearly postretirement increases to a pension awarded so that a participant's buying power is not eroded over time by inflation—is so significant that failure to include COLA coverage in a QDRO or court order can also be devastating.

Consider the case of a Civil Service Retirement System (CSRS) retiree who divorced and retired in 2004 at the age of 55 with 30 years of credited service. His total accrued pension was $1,000 per month. Because the entire pension was earned during the marriage, his former spouse was awarded a monthly benefit of $500 as her equitable share of the pension. However, the court order that granted the former spouse $500 per month was silent on the issue of COLA increases. In 20 years if the Consumer Price Index increases by an average of 2.5% a year, the participant will be receiving $1,138 per month while his former spouse is still receiving $500 per month.

The impact of COLA on present values can be quite significant. Using current interest rates, the present value of $1,000 a month for life for a 55 year old male is $205,794. However, if a modest 2.5 percent annual compounding COLA is assumed, the value jumps 37.6 percent to $283,376.

Missed COLA protection in the Court Order Acceptable for Processing – the name for court orders dividing federal government pensions – may account for a dramatic disparity in the income of the two parties in the years that follow. As we just explained, if the participant is awarded 100 percent of COLA increases from Civil Service as his sole and separate property, he is actually receiving a 5% annual COLA as sole and separate property.

Date Effective	Amount of Adjustment	Date Effective	Amount of Adjustment
Jan. 1989	4.0%	Jan. 1997	2.9%
Jan. 1990	4.7%	Jan. 1998	2.1%
Jan. 1991	5.4%	Jan. 1999	1.3%
Jan. 1992	3.7%	Jan. 2000	2.4%
Jan. 1993	3.0%	Jan. 2001	3.5%
Jan. 1994	2.6%	Jan. 2002	2.6%
Jan. 1995	2.8%	Jan. 2003	1.4%
Jan. 1996	2.6%	Jan. 2004	2.1%

COLA for the last 10 years averages out to 2.37% per year and 2.4% for the last 5 years. However, despite the record low rates of inflation for the last five years the inflation awards have dropped below 2.4% only 4 times in the last 25 years.

Practice Tip: Including a conservative COLA on the order of 2.4 percent per year allows the nonparticipant spouse to share in the funding of the growth component earned during the marriage.

What may be described as the ongoing COLA Wars usually begin with the participant making three claims. First, it is argued that because the increases occur after the divorce, they should be considered nonmarital assets. Second, it's asserted that even if COLAs are considered a marital asset subject to equitable distribution, they are so speculative that they defy analysis and must be ignored. Third, the participant points to potential government cutbacks in COLAs and argues that by the time of retirement, COLAs may be a relic of the past.

Countering “UnCOLA” Claims COLA aficionados counter that COLAs are virtually guaranteed over any extended time period and are too valuable to be awarded as the sole and separate property of the plan participant. A plan's actuaries must fund for future COLAs on an ongoing basis. They are as much deferred wages as the basic pension itself; therefore, COLAs are funded and earned during the marriage. Admittedly, predicting the exact size of each year's increase in the consumer price index (CPI is the usual trigger for COLA increases) is impossible; however, over time, some level of inflation is endemic to our economy. To conclude that inflation will never appear again (the position of COLA haters) is in itself a wildly speculative assertion.

The argument that COLAs are so costly to government plans that they might be scaled back at some future time has some merit. The Boskin Commission concluded that the CPI overstates actual inflation by about 1 percent. This study has many harsh critics. The fact that reducing COLAs by 1 percent over the next decade could save some $634 billion is not lost on politicians. But neither is the incredible resistance of plan participants to cutbacks in their benefits. Most politicians recognize that significant changes in government pensions are as dangerous to their futures as touching the third rail beneath the subway train.

Cutbacks in COLAs have taken place in other government plans Government employees hired after 1984 participate in the Federal Employees Retirement System (FERS) and receive the actual change in the CPI when it increases from 0 to 2 percent. When the CPI increase is in the 2 to 3 percent range, the participant realizes a 2 percent increase. When the CPI increases by more than 3 percent, the COLA award equals the actual CPI increase, minus 1 percent. The CPI minus 1 percent approach is used for members of the military who began plan participation after August 1, 1986. Tier II pensions with the Railroad Retirement Board are awarded 32.5 percent of the actual CPI change.