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Social Security just announced its 2013 Cost of Living increase. Thanks to an incredibly low rise in the official inflation benchmark, the typical retiree will see his or her payment increase a mere 1.7%. On average, payments to retirees are rising from $1,240 per month to $1,261 per month -- about $21 per month, or $0.70 per day.  

If you're scratching your head and wondering how exactly they figured your costs of standing still rose by a mere $0.70 per day over the past year, you're not alone. The unfortunate reality is that if you're a senior relying on Social Security, your costs of living probably did rise faster than that official level, since the benchmark they use doesn't really reflect seniors' costs.

Where the numbers go wrong
The government uses the "CPI-W" index to adjust Social Security payments. That index measures the impact of inflation on "Urban Wage Earners and Clerical Workers"  -- not retirees. There are two huge reasons that that number underestimates the real inflation rate for a typical retiree: health care and hedonic adjustments.

Health care: On average, the older you are, the more you spend on health care. What that means is that as you age, the amount you're anticipated to spend on health care goes up, regardless of the inflation rate. On top of that "natural" increase in costs you see due to aging, health care expenses have been rising faster than the overall inflation rate for decades. That combination means seniors are seeing big increases in an expense that affects them more than the folks modeled for the inflation calculation.

Hedonic adjustments: When the government calculates the CPI, it adjusts for changes in item quality over time and innovation through a statistical process that it calls "Hedonic quality adjustments." As a result, the out-of-pocket cash you shell out for something can actually go up, but the hedonic adjustment for quality improvements means that the item looks like a cost decrease to the CPI number.

As confusing as that seems, here's an example from the Bureau of Labor Statistics' (the folks who calculate the CPI) own website:

Old Television (Before Adjustments)

Old Television (After Adjustments)

New Television (Not Adjusted)

$250 Price Tag

$1,345.02 Price Tag

$1,250 Price Tag

27" Screen Size

42" Screen Size

42" Screen Size

Cathode Ray Tube Display

Plasma Display

Plasma Display

EDTV Resolution

HDTV Resolution

HDTV Resolution

S-Video Input

S-Video Input

S-Video Input

Universal Remote

Universal Remote

Universal Remote

Source: U.S. Bureau of Labor Statistics.

As a result, the available replacement for a television that used to cost $250 will now run you a cool $1,250, but that heftier real world price tag actually looks like a 7.1% decrease to the CPI. It's more money out of your pocket to buy a television -- which is what you as a consumer feels -- but the CPI says more than 100% of that increase is driven by quality improvements, not inflation.

Those types of adjustments, which also hit clothing & typical household appliances, mean that your out-of-pocket spending could very well be rising faster than inflation, even if you're not buying more stuff. Sure, the quality may be better, but that's small comfort when the larger amount of cash you need to shell out for any given item means you've got all that much less to spend on everything else. It forces you to be more choosy and makes you feel poorer, even if the CPI says that statistically, you're not.

If that weren't bad enough...
Yet even though Social Security payments aren't enough to keep up with seniors' real costs of living, the program's Trust Fund is on a path to run out of cash around 2033, slashing benefits by about 25%. That's barely more than 20 years from now -- well within the expected lifespan of most of today's workforce and even some of the younger retirees currently collecting from the program.

With Social Security on the rocks, that leaves pensions and individual savings to make up the gap. But pensions are largely a dying breed, and there's something of a crisis when it comes to individuals saving on their own for their retirements. The stark reality that prospective retirees face is one where the social safety net is frayed and employers can largely no longer be counted on to reward their employees for a dedicated career of service.

The only lever left with any real chance of helping you through your retirement is your own investing, through 401(k)s, IRAs, and even plain old-fashioned investment accounts. It's not easy, and it takes decades of discipline to make it work, but the alternative is a truly gruesome retirement.

The best investing approach is to choose great companies and stick with them for the long term. In our free report "3 Stocks That Will Help You Retire Rich," we name stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.

Fool contributor Chuck Saletta welcomes your feedback.Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (9) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 17, 2012, at 10:41 AM, TMFDarwood11 wrote:


    Thanks for the primer and including "hedonic adjustments.' I've had a few discussions with friends and family about this approach over the years.

    I also agree with your comment "The only lever left with any real chance of helping you through your retirement is your own investing, through 401(k)s, IRAs, and even plain old-fashioned investment accounts. It's not easy, and it takes decades of discipline to make it work, but the alternative is a truly gruesome retirement."

    It does take decades. I posted a comment over at Morgan Housel's "9 Financial Rules You Should Never Forget."

    Our personal finances are the only lever that we, as individuals, have any control over. Trust the government and trust the employer to take care of ME? That's taking a long leap of faith. Companies and the government have a lot of issues to balance, and for the company that includes shareholders. So thinking that we, as individuals, are the most important thing for these entities is a real personal mistake, and will end in tragedy.

  • Report this Comment On October 17, 2012, at 7:13 PM, wpost41 wrote:

    I hope your right about the increase on social security for 2013. We have not had a raise in three years, and last time we got one, Medicare took it back due there rate hike.

  • Report this Comment On October 17, 2012, at 7:32 PM, kthor wrote:

    I can't wait to retire in 25 yrs and see how much SS iam going to get LOL, thank god for 401k and other investments SS will be my pocket money ...

  • Report this Comment On October 17, 2012, at 7:38 PM, dcorley wrote:

    All right. 70¢ a day. I wish I had 70¢ a day when I was a kid.

    Seriously, I ride a bicycle. Am retired. 70¢ is about all I should eat every day to be healthy. Beans and cornbread.

    Enjoy what you have. Whining about what could have been is non-productive.

  • Report this Comment On October 18, 2012, at 11:02 AM, BabaRamDass wrote:

    <b>Enjoy what you have. Whining about what could have been is non-productive.</b>

    So true.

    Whining about what you <b> should </b> have (from Social Security) is equally unproductive. As if there's some objective standard involved.

    I'm almost 69; have other resources; and am totally grateful for the boost to my income from Social Security.

  • Report this Comment On October 18, 2012, at 1:03 PM, Melaschasm wrote:

    The hedonic adjustments generally favor retirees. They could replace their old 27" TV with a higher quality 32" LCD for $300, even though the inflation adjusted cost of replacement is $1200. In this example the hedonic adjustment favors those receiving benefits by $900. While most such adjustments are far less favorable, they tend to benefit seniors.

    Healthcare costs are rising much faster than inflation, but that is partially offset by the rapidly rising Medicare spending. Overall people living on social security today are better off than those depending upon the system two decades ago.

  • Report this Comment On October 18, 2012, at 1:04 PM, HardRain2012 wrote:

    The CPI is rigged. Reagan and Clinton fiddled with the formula and now the truth is that SS benefits would be 70% more if the the 1980 formula was still being used. Also, SS revenues are down because while productivity has about doubled in the past three decades, real wages, even by the dodgy formula of the CPI, are flat. In reality, real wages have fallen precipitously.

  • Report this Comment On October 18, 2012, at 1:32 PM, TMFMorgan wrote:

    Worth noting:

    "It is also important to emphasize that the BLS makes hedonic adjustments for declines, as well as improvements, in quality. The CPI price indexes for shelter include hedonic adjustments for the gradual aging of the rental housing units in the CPI sample, and those adjustments regularly increase the rate of change of the indexes by at least 0.2 percentage point per year. The hedonic adjustments in apparel have had both upward and downward impacts at different points in time and for different categories of clothing. As discussed in an article in the Monthly Labor Review, the BLS estimates that the hedonic quality adjustments introduced since 1998 have had an upward impact in five item categories and a downward impact in five. The overall impact of these newly introduced hedonic models has been quite modest and in an upward, not downward, direction. To be precise, the use of the models has increased the annual rate of change of the all-items CPI, but by only about 0.005 percent per year. It is clear, therefore, that those who maintain that the BLS uses hedonic adjustment to keep the measured rate of inflation in an acceptably low range are wrong about the impacts, as well as the motives, of BLS actions."

  • Report this Comment On October 18, 2012, at 4:31 PM, justaboutperfect wrote:

    CPI was rigged by the Lobbyists and special interests groups who helped Congress fiddle with the formula during Reagan's "Trickle down economics for the middle class and Gusher up economics for the rich".

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