Social Security COLA: What's working, what's not

Financial economists are in love with the idea of an inflation-indexed annuity because it eliminates two of the most important risks in retirement — inflation and outliving assets. A retiree gets an income that never runs out and provides the same lifestyle each year.

The only remaining provider of inflation-protected annuities in the United States is the federal government through Social Security. Retirees today can buy more of this income by waiting until age 70 to claim Social Security, thereby boosting their inflation-protected income by 30% over their full retirement age.

For healthy, higher-income retirees who have seen the largest improvements in longevity in recent decades, this increase in lifetime inflation-protected income appears to be a bargain.    

In fact, inflation protection means that the value of $2,000 in Social Security income at age 70 is greater than receiving $2,300 in a lifetime nominal pension (that will not rise with inflation). 

The inflation protection provided through Social Security is an often overlooked but important benefit that makes it a valuable tool for funding basic retirement expenses.  

How are Social Security benefits adjusted for inflation, and can we expect these annual income increases to continue in the future?  Does the inflation adjustment do a good job of increasing income when retirement expenses rise? 

The expected shortfall in the Social Security trust fund means that policymakers will soon be looking for ways to shore up the system’s finances. Reducing inflation adjustments offers the dual political benefit of avoiding a reduction in size of Social Security checks and reducing the size of future payroll tax increases.

Should advisors be worried that this important benefit will disappear?

The importance of automatic Social Security COLAs

Social Security recipients will receive a 1.3% cost-of-living adjustment (COLA) to their monthly benefits beginning in January 2021. The average Social Security retirement benefit in 2020 is around $1,500.

Therefore, the “average” retiree will receive approximately a $19.50 increase in their monthly benefit check, or $234 for the year. This increase is on top of the 1.6% increase for 2020.

Social Security benefits only rise when prices go up; in years with low price inflation, they remain steady.

Protection against the erosion of purchasing power is particularly important today as people are living longer than ever before and rising health care costs often lead to unexpected expenses that can drain savings in retirement.

In order to keep inflation from eroding purchasing power, benefits are purposefully designed to increase with price inflation and without political interference. 

Legislation enacted in 1972 required that beginning in 1975, future cost-of-living adjustments to Social Security and Supplemental Security Income (SSI) benefits be tied to the Consumer Price Index. This also ensures that COLAs do not require yearly congressional action and are not tied to the direction in which the political winds blow.

How are Social Security COLAs determined?

The Social Security Act specifies that any COLA be based on the percentage increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) from the third quarter of the previous year to the third quarter of the current year. 

If a COLA is warranted, it shows up in benefit checks beginning the following January. If there is a decrease in the CPI, or deflation, no COLA is provided.

Further, no COLA can occur in subsequent years until the CPI exceeds the previous high point. This is why there was no COLA in 2010, 2011 and 2016. 

Can Social Security benefits decrease?

Though benefits can increase, it is important to note that Social Security benefits never decrease, even during periods of deflation and a decline in the CPI.

Even though the United States is currently experiencing high unemployment, low economic growth and record high levels of national debt because of the pandemic, Social Security benefits appropriately increase purchasing power for retirees. 

In some years, the COLA can be quite large. For example, the COLA for 2009 was 5.8%, the largest increase since 1982.

However, this larger than normal COLA in 2009 was primarily a result of significant increases in the price of gas and energy during the spring and summer of 2008, when prices for gasoline reached $4 per gallon.  

In other years, the COLA can be low or even 0%. In 2010 and 2011, there was no COLA for Social Security beneficiaries after gas and energy prices declined, resulting in a lower CPI.

If there is a decrease in the CPI (or even deflation), no COLA is provided and no COLA can occur in subsequent years until the CPI exceeds the previous highest level. This is why there was no COLA increase in 2010, 2011, and 2016. 

Medicare Premiums and Social Security COLAs

Many Social Security beneficiaries also rely on Medicare to cover their health costs. Medicare Part B and Part D premiums are automatically deducted from beneficiaries’ Social Security benefits.

In the absence of a COLA, however, Medicare Part B premiums are not allowed to rise for most Social Security beneficiaries.

While Medicare helps pay for many health-related costs, such as doctor visits, inpatient hospital care, nursing care, medical services and devices, it does not cover long-term care.

CPI-W vs. Chained CPI 

The Consumer Price Index (CPI) measures the average change in prices paid by consumers for a market basket of consumer goods and services. Since budget shares differ among consumers, there are indexes built to weight components of the market basket differently.

For example, the most common measure of price inflation is the CPI-U, Consumer Price Index for All Urban Consumers. Social Security uses the CPI-W (Consumer Price Index for Urban Wage Earners and Clerical Workers).

A criticism of using a basket of goods and services is that consumers will substitute other goods or services when prices rise. If beef prices rise, retirees will eat more chicken. 

The CPI-W takes this substitution effect into account, but some argue that it only accounts for low-level substitutions of close substitutes rather than high-level substitutions (such as buying more eggs for protein). 

The Chained CPI-U (Chained Consumer Price Index for All Urban Consumers) employs a formula that reflects the effect of substitution that consumers make across item categories in response to changes in relative prices.  

In 2012, the Chained CPI made national headlines as a possible solution for reducing the growth in Social Security benefits. Conservative groups (opposed by senior organizations such as the AARP) promoted the Chained CPI as a relatively painless way to cut over $100 billion from Social Security income over the following decade. 

The impact on income payments is relatively modest, resulting in growing benefits just a little bit less — an estimated 4% less by 2050.

CPI-W vs. CPI-E

Opponents of the use of more modest CPI measures point out that inflation may be underestimated by an index that doesn’t reflect the budget of a retiree. Some have proposed switching to a COLA index more appropriate for seniors, such as the CPI-E (for the elderly). 

Unfortunately, the CPI-E is experimental and the Bureau of Labor Statistics warns that the CPI-E has significant methodological limitations that affect its ability to accurately capture changes in prices paid by retirees. Regardless of these limitations, the CPI-E actually closely tracks the other common measures of price inflation such as the CPI-W and Chained CPI.

Congress has introduced legislation that would tie future adjustments to the CPI-E. 

The Social Security Administration’s Office of the Chief Actuary estimated in 2010 that basing future adjustments on the CPI-E would provide average annual COLAs that were about 0.2 percentage points higher than adjustments based on the current CPI-W. For 2020, had the CPI-E been used for COLAs, the increase would have been 1.9% instead of 1.6%, or 0.3 percentage points higher.

However, even though the CPI-E closely tracks the CPI-W, in some years, it was less than the CPI-W. For example, recalling the large COLA in 2009 and subsequent zero-COLAs in 2010 and 2011, if cost-of-living adjustments had been based on the CPI-E, there would actually have been a smaller increase in 2008 and there still would not have been an increase in 2009 or 2010. 

About 64 million Americans rely on Social Security benefits for income protection, including more than 48 million retired workers and their dependents. 

Among households headed by someone aged 65 or older, more than half rely on Social Security benefits for a majority of total income, while 19% depend on Social Security for at least 90% of income. The automatic cost-of-living adjustment to Social Security benefits helps ensure that retirees are protected against inflation risk. 

Planning for future retirement expenses

One of the most difficult aspects of planning for expenses in retirement is estimating the cost of health care over an uncertain lifespan. 

Over the past two decades, the Medical Care Services category of the CPI experienced one of the highest increases in price inflation. 

As retirees live longer, financial advisors will need to help people plan for the high costs of assisted living facilities. The median cost of assisted living care was $51,600 a year in 2020, while the median cost for a private room in a nursing home was $105,850, according to the Genworth Cost of Care Survey. 

While the Social Security COLA is based on the CPI-W, which itself is based on eight major categories of spending, it is not a perfect measure of everyone’s cost of living.

Budget shares for housing, energy and food may be higher for retirees in certain regions, while the cost of health care rises with age. Younger and wealthier retirees may spend more on leisure and travel.

Financial advisors need to recognize that changes in Social Security likely will not match changes in their clients’ expenses, making the inflation protection an imperfect hedge against price volatility. 

Social Security COLAs are designed to increase purchasing power enough to keep Americans out of poverty. Managing inflation for a wealthy retiree requires different strategies that may involve the use of insurance to protect against health cost risks and investments that historically outpace price increases. 

The future of Social Security COLAs

Numerous legislative proposals have been introduced over the years to change the way the Social Security COLA is calculated. Some proposals have suggested adopting the previously mentioned CPI-E, while others have suggested moving to a Chained CPI, which would account for changes in the goods and services consumers buy each year.

Regardless, there are no serious proposals to eliminate the Social Security COLA. Current and future retirees should continue to expect that Social Security benefits will be adjusted for some measure of increase in prices. 

However, the Social Security and Medicare programs themselves face financial problems, which could lead to future changes in benefits and possibly in the use of a more modest COLA index.

According to the Social Security Trustees, the combined OASI and DI trust funds face a financial shortfall of $16.8 trillion in present value through 2094 and $53.0 trillion over an infinite horizon.

Further, the Social Security trust funds will be depleted and unable to finance full benefits in 2035.

Unless Congress takes action to reform Social Security, the program will only be able to pay approximately 75% of estimated benefits when the OASI trust fund runs out of assets in 2035.

The Medicare program also faces a funding shortfall, with the most recent estimates suggesting that the hospital insurance trust fund could be depleted in 2026.

Financial advisors will need to help clients navigate the uncertainty and risk associated with the impact that the impending depletion of the Social Security trust funds will have on Social Security retirement benefits, Medicare premiums and retirement security.

Jason Fichtner is the associate director of the Master of International Economics and Finance Program at the Johns Hopkins School of Advanced International Studies. Michael Finke, Ph.D., CFP, is a professor of wealth management and Frank M. Engle Distinguished Chair in Economic Security at The American College of Financial Services.