For many, Social Security will be the financial lifeline that keeps them afloat during retirement. As a country with a generally poor savings rate, it's probably not surprising to learn that 62% of today's retired worker beneficiaries lean on their payout to account for at least half of their income. For 34% of retired workers, Social Security pretty much is their only source of income.
Thus, there's no announcement that's more important, or anticipated, each year, than when the Social Security Administration dishes on the cost-of-living adjustment (COLA) in the second week of October. COLA is a fancy way of describing the percentage "raise" that all 63 million Social Security beneficiaries will be receiving in the upcoming year.
Continue Reading Below
Understanding the importance of cost-of-living adjustments
Thanks to amendments signed into law in 1972 by President Richard Nixon, the Social Security program has had its COLA reviewed annually since 1975. Prior to this point, benefit increases were passed along arbitrarily by special votes of Congress to account for cost-of-living increases.
Since 1975, the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) has been the program's inflationary tether. The CPI-W has eight major spending categories and dozens upon dozens of subcategories, each with their own respective weightings. As the prices for these goods and services rises and falls, the CPI-W is able to express aggregate inflation (rising prices) or deflation (falling prices) with a single numerical reading.
Of course, there are some unique aspects of Social Security's COLA calculation. Specifically, only the average CPI-W reading from the third quarter matters (i.e., July through September). The other nine months might help us identify trends with overall pricing, but they won't factor into Social Security's COLA calculation. Put plainly, if the average CPI-W reading from the third quarter of the current year is higher than the average CPI-W reading from the third quarter of the previous year, beneficiaries are getting a raise that's commensurate with the percentage increase, rounded to the nearest 0.1%.
It's also worth pointing out that a special provision exists to prevent Social Security benefits from declining in the event of deflation. Only three times since the CPI-W became the program's inflationary tether in 1975 has deflation taken hold (2009, 2010, and 2015). Thankfully, benefits remain static during periods of deflation, meaning that in the subsequent years (2010, 2011, and 2016) recipients were paid the same amount per month as they received in the previous year.
Sounds like a pretty straightforward means of ensuring that beneficiaries are keeping up the rising price of goods and services, right? Well, not so fast.
A Social Security dollar doesn't go nearly as far anymore
Social Security's inflationary tether has a pretty major flaw. Namely, it's focused on the wrong group of people. Just look at the name of the program's COLA tether, the Consumer Price Index for Urban Wage Earners and Clerical Workers. Urban and clerical workers are liable to be of working age, and they're almost certainly not going to be receiving a benefit from the Social Security program. Yet, their spending habits are what currently dictates the COLA that's passed along to more than 63 million beneficiaries.
This is a problem -- a big problem. Despite 70% of all beneficiaries being retired workers, and 76% of all benefits paid monthly heading to these retirees, the costs that are most important to these seniors aren't being accurately represented in the existing COLA calculation. That's because working-age Americans usually have much lower medical care and housing expenses, while spending more on education, apparel, transportation, and other categories that simply aren't that important to retired workers. The end result is that seniors don't receive a COLA that adequately covers the inflation they've been contending with. Or, to put things another way, the Social Security dollars seniors are receiving simply aren't going as far as they used to.
Just how bad has this loss of purchasing power been for elderly Americans receiving a Social Security benefit? In a newly released report from The Senior Citizens League (TSCL), policy analyst Mary Johnson finds that the purchasing power of benefits has declined by 33% since the year 2000.
In 2000, the national average Social Security benefit was $816 a month. Inclusive of two decades of COLAs, an individual today would be receiving $1,226.60 a month, representing a nominal increase in payout of 50%. But if this same $816 rises on par with the inflation of 39 common household expenditures for seniors through 2019 (as measured by TSCL), it would work out to $1,634.50 a month, or a 100.3% increase. The average senior would need almost $408 extra per month just for their benefits to be where they were in the year 2000.
Social Security's COLA problems are here to stay
Perhaps just as much of a slap in the face as the persistent loss of purchasing power is the fact that both Democrats and Republicans agree the CPI-W is flawed, but neither party can find the common ground needed to fix it.
Democrats have offered an idea to increase COLAs over the long run by switching to a measure called the Consumer Price Index for the Elderly (CPI-E). As its name implies, only households with persons aged 62 and over would factor into the calculation, which should more accurately reflect the spending habits of seniors. The issue is that the CPI-E has long been considered by the Bureau of Labor Statistics to be an experimental inflationary measure, and it'd likely require some lengthy and costly refinement before it were put into use. That and Republicans in the Senate won't vote in favor of the CPI-E, dooming any proposed Social Security amendment in the upper chamber of Congress.
As for Republicans, they favor switching to the Chained CPI from the CPI-W. The Chained CPI takes into account the idea of substitution bias, or trading down to a similarly priced good or service when another gets too pricey (e.g., buying pork or chicken if ground beef prices rise a lot). Although this is a real-world consumer behavior, it'd actually result in lower COLAs over the long run and is a means of reducing Social Security outlays. In short, it would almost certainly exacerbate the loss of purchasing power seniors are contending with, not making it better. And, you probably guessed, Democrats won't support the Chained CPI as a replacement for the CPI-W.
Thus, we have a stalemate. The purchasing power of Social Security dollars has been and will continue to decline over time, and there's nothing on the horizon to suggest that lawmakers have a fix at the ready.
The $16,728 Social Security bonus most retirees completely overlook If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,728 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.
The Motley Fool has a disclosure policy.