When the Social Security Administration first started paying out benefits in the 1940s, there was no provision in place for how to deal with inflation. Unfortunately, this meant that early beneficiaries saw the buying power of their benefits eroded as the years went by. This is why the Social Security Administration enacted the annual cost-of-living-adjustment (COLA) provision as part of the 1972 Social Security Amendments, and automatic annual COLAs began in 1975.
Though annual COLA increases have now been part of Social Security benefits for over 40 years, beneficiaries do not necessarily receive COLA increases each year—and those increases can be lower than the rate of inflation. Understanding how the Social Security Administration determines the COLA rate is an important part of planning for your own benefits so that you’ll never be caught flat-footed by either low increases or inflation. Here’s what you need to know:
How Is COLA Calculated?
The Social Security Administration uses an index known as the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) in its current formula to calculate the annual COLA for beneficiaries. The CPI-W tracks the overall inflation of goods, and offers a reasonable benchmark for determining how large an increase Social Security beneficiaries should receive so that their benefits keep pace with inflation.
Criticisms of Using CPI-W for the COLA Calculation
Though the CPI-W does provide a general sense of the overall inflation of the market, there are some downsides to using it for the COLA calculation. First, the CPI-W does not take into account what economists call the elasticity of demand. Such elasticity occurs when the price of one type of good goes up, so frugal shoppers decide to buy a different good. For instance, if the price of beef were to go up, many consumers would choose to buy other meats or meat substitutes instead.
This elasticity of demand is why some economists and experts suggest switching the COLA formula to one that uses something called a chained CPI. This kind of index reflects the fact that consumers make purchasing substitutions when prices rise, which means the chained CPI rate of inflation is calculated at about 0.3 percentage points lower than the CPI-W.
However, other critics worry that rather than providing too large a COLA, the CPI-W does not provide enough of an adjustment to offset the specific types of inflation that most affects seniors. Older consumers are more likely to use goods and services that are difficult to find lower-priced substitutions for, such as medicine and healthcare.
Considering the fact that healthcare costs increased by an average of 6.4% per year between 1993 and 2010, it’s understandable that many beneficiaries and elder advocates worry that COLA increases are too small.
How Much to Expect in Annual COLA Increases
The Social Security Administration has announced that the 2018 COLA increase will be 2%. This will be effective as of December 2017, and beneficiaries will see this increase upon receiving their January 2018 benefits. While 2% is a relatively low increase, it is still the largest COLA increase since 2011. There was no COLA increase for 2016, and 2017 only saw a COLA of 0.3%.
Falling gas prices were partially responsible for lack of a COLA increase in 2016. Unfortunately, since the majority of Social Security beneficiaries no longer need to commute, low fuel prices did not necessarily offset cost-of-living expenses that did experience inflation. For many seniors on fixed incomes, seeing no COLA increase in 2016 was a stressful exercise in pinching pennies.
Making Your Benefits Inflation-Proof
2016 was not the only time in recent memory that current beneficiaries saw no increase. In the aftermath of the 2008 market downturn, there was no COLA increase for 2009 or 2010. While the lack of a COLA increase may have reflected the reality of slow inflation in our economy, it was still devastating for many beneficiaries.
There are several ways to make sure you are not overwhelmed by inflation, whether or not the Social Security Administration provides an ample COLA increase. Here are three ways to protect your benefits from inflation:
- Wait as long as you can to take your benefits. The longer you wait between age 62 and age 70, the higher benefits will be. For each year that you wait, your monthly benefit increases by approximately 8% per year, which can make a big difference in cushioning your retirement income from the vagaries of inflation.
- Adjust your spending based on COLA announcements. The Social Security Administration announces the next year’s COLA increase every fall, which means beneficiaries have time to prepare before low- or no-COLA increase years. For instance, if you receive a $2,000 per month benefit, receiving a 2% increase is only $40 per month. If you know that no increase will be coming, you have some time to find $40 per month to trim to help make up the difference.
- Have Medicare Part B premiums deducted from your benefits. Having your Part B premiums deducted from your Social Security benefit can potentially help you to weather no-COLA increase years. That’s because of something called a “hold harmless” law: If Medicare premiums rise, but the COLA does not, beneficiaries who have their Part B premiums deducted from their Social Security benefits will not see those premiums rise. The law specifies that Medicare Part B premiums cannot go higher than the previous year’s COLA increase.
Preparing for Cost of Living in Retirement
In an ideal world, the Social Security Administration would find a COLA formula that covered all cost of living increases for all beneficiaries every year. Since that’s not possible, individual beneficiaries needs to plan ahead for the effects of. In your ideal retirement, your COLA increases will be nice bonuses to your retirement income rather than something you count on to stay afloat.
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This information is not intended to be legal or tax advice. The presenter can provide information, but not advice related to social security benefits. Clients should seek guidance from the Social Security Administration regarding their particular situation. Social Security benefit payout rates can and will change at the sole discretion of the Social Security Administration. For more information, please consult a local Social Security Administration office, or visit www.ssa.gov.