It’s the first of the year and it seems an appropriate time for my rant about cost of living adjusters (COLA) in bank technology contracts. For years I have taken the position that COLA is expensive, unwarranted and, most of all, a deterrent for the provider to become more efficient. In spite of the fact that hardware is subject to Moore’s Law and gets faster and cheaper, bank software contracts are subject to Gonzo’s Yelp Paradigm (GYP), which states:
“The cost of banking software and banking technology services increases as long as the existing contract has not terminated or is in process of being renewed.”
Today is not the time to discuss how egregious this process is; rather, this is the time to explain how the COLA process actually works. I continue to find substantial confusion about the actual calculation. This primer should be on the shelf of every bank CIO and CFO.
Here are the COLA terms in a contract I recently reviewed:
Contract Length – Six years
Adjustment Rate – 6%
Frequency of Adjustment – Annually
Annualized Payment Amount – $500,000
Cornerstone’s normal process when assisting a bank choosing a new system is to create a five-year pricing model of the proposed contract. All of the pricing points proposed (accounts, transactions, etc.) as well as the bank’s planned growth are included. This is the only realistic way to see the Total Cost of Ownership (TCO). Most factors in the model can be changed to determine its impact. For instance, you may want to change growth assumptions to see the impact of an acquisition.
COLA is calculated and displayed on a separate line to expose the real cost. Showing the amount in this manner has resulted in quick reactions from our clients regarding the accuracy of our calculation. The response is always, “You have calculated the COLA adjuster incorrectly, it is too high.” The confusion almost always occurs because COLA appears to work like loan interest. If you think like that, 6% doesn’t seem like a bad adjustment. In fact, for the example above, that’s going to be around $30,000 per year; with compounding it will grow to $38,000 by end of contract. Wrong, wrong, wrong.
Do you know what the adjustment in the last year of the contract will be? Assuming the annual payment is still $500,000, the COLA increment is not $38,000, it will be $169,100! The amount of adjustment in the sixth year is 33.82%. Now you see why the CFO is calling to let us know the model has errors. You can also see why I believe the entire COLA scheme is egregious and must be challenged when negotiating your contract.
Understanding how COLA works requires a careful reading of your contract. Most contracts will have wording that reads like this:
“The fees for services shall be increased by 6% on each anniversary of the effective date.” This looks like 6% interest; in fact, it probably should read “an additional 6%.” Look at the following table to understand how this is not only compounding, but the addition of 6% more every year.
The impact of the adjustment now becomes very obvious. Sure, the amount is compounding but, unlike interest, the rate goes up an additional 6% every year.
Ahhh, now that you have seen the light, let’s discuss what can be done about the problem.
Unless your current vendors are really, really understanding, you have few options with existing contracts. However, if you have a 10-year deal and the COLA adjuster is costing you in a major way, it’s worth having a conversation with your account representative.
The argument you will always get is that our costs are increasing, payrolls are increasing, yadda, yadda, yadda. Yep, so are yours, but the competition won’t let you raise your prices, you must be more efficient.
You are probably going to have to live with some kind of COLA adjuster, but you can dampen its effect by doing the following:
1. Try to get the adjuster removed or frozen for the first few years.
2. Allow the amount to adjust to the lower of an external index or a fixed maximum such as 3%.
3. Keep the contract short if you are unable to get reasonable consideration for COLA.
The facts are simple; the latest Cornerstone Report indicates banks still spend about 0.26% of average assets each year for technology. That number has not significantly changed in five years. Given that total costs are not increasing, why should you commit to a contract that ensures your costs will increase over time?