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When you file for Social Security benefits, your lifetime earnings are applied to a formula in order to determine the amount of your retirement benefit. However, this amount isn't set in stone -- it will rise over time to keep pace with the increasing cost of living, and it does so by an annual process known as the cost-of-living adjustment, or COLA.
How the COLA is calculated
Thanks to the Social Security Act, Social Security and SSI benefits will increase automatically if there is an increase in inflation.
There are several ways inflation can be measured, and Social Security uses an index known as the Consumer Price Index for Urban Wage Earners and Clerical Workers, also known as the CPI-W. Basically, this index is designed to track the expenditures of American households, and is expressed as a number relative to the average cost of living during the three-year period from 1982-1984. As an example, the base value of the CPI-W is 100, so a value of 105 would represent a 5% increase in the cost of living.
To determine the COLA, the CPI-W during the third quarter is compared to the third quarter of the previous year. If it is determined that the CPI-W has increased between the two periods, a COLA is made in order to maintain the purchasing power of retirees' benefits.
In addition to determining Social Security benefit increases, an increase in this index also allows for a change in the maximum amount of earnings subject to Social Security tax (currently $118,500) and the retirement earnings test exempt amounts, which determine how working can reduce Social Security benefits.
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No change for 2016
It's important to point out that since the COLA depends on inflation, an increase doesn't necessarily happen every year. In fact, it was announced in Oct. 2015 that Social Security benefits would not increase for 2016, as the CPI-W did not increase from the previous year. It's also important to note that if the cost of living decreases, benefits are not adjusted downward.
Deflation is pretty rare, and there have only been three times since 1975 when no COLA was given, but it does happen. For example, between 2008 and 2009, the CPI-W actually decreased by about 2%. However, Social Security benefits remained the same in the following year.
Could the COLA calculation change?
It's possible that a different method could be used to calculate the COLA in the future, depending on who gets their way whenever Social Security reforms are done.
Some say that the current method doesn't take into account the costs that affect seniors the most, such as out-of-pocket healthcare costs, and that the COLA method should be modified to more accurately reflect this. On the other hand, the case can be made that switching to a slower-growing index, such as the so-called "chained" CPI, could help solve Social Security's projected funding shortage.
Since we're getting to the point where Social Security will need an overhaul, it's entirely possible that a change in the COLA calculation method will be a part of any reform package, so stay tuned.
The article How Are Social Security Cost-of-Living Adjustments Calculated? originally appeared on Fool.com.
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