It's obvious to any consumer that prices tend to go up over time, and the federal government is aware of this as well. In order to keep Social Security benefits in line with the rise in prices each year, the benefits are subject to a Cost-of-Living Adjustment (COLA). Unfortunately, the COLA isn't exactly synced up with reality.
How COLA is determined
The Bureau of Labor Statistics maintains the Consumer Price Index (CPI), a database that tracks changes in prices for a wide range of goods and services. Changes to the CPI indicate inflation or deflation at work: for example, if the CPI rises by 2% one year, then the inflation rate for that year is said to be 2%. And like inflation, Social Security's COLA is also tied to the CPI change for the year. Since inflation has been extremely low for the past several years, recent COLAs have also been very low (or even nonexistent). For 2017, the COLA is 0.3%.
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Problems with the COLA approach
The CPI is designed to be representative of prices as a whole, and the Bureau of Labor Statistics selects which products and services it tracks in an attempt to reflect what the average urban dweller would spend money on. Unfortunately, this choice of products and services is not a great fit for many retirees.
For example, medical expenses have been rising much more quickly than most other expenses. The CPI does track medical expenses, but it also tracks many other expenses that retirees are less likely to use than younger consumers, such as electronic purchases. Because all these expenses are averaged together, the slower-to-change expenses drag down the average rate compared to steeply rising medical expenses.
Thus, the Social Security COLA has gone up far more slowly than medical inflation. Over the long term, the average annual healthcare inflation rate is 5.39%, compared to average annual overall inflation of just under 3%. In 2016 alone, the healthcare inflation rate was 3.13%-yet the Social Security COLA was 0%.
"Hold harmless"
By law, Social Security benefits to a particular recipient can't go down from one year to the next -- this is referred to as the "hold harmless" provision.
Because Medicare Part B premiums are subtracted right from the benefits checks, those premiums can't go up more than the COLA for the year. For example, in 2016 the COLA was zero, so retirees who'd gotten Social Security benefits in 2015 saw no increase in Medicare Part B premiums in 2016.
However, the hold harmless provision doesn't affect someone who's receiving benefits for the first time that year, since there's no previous benefit amount to compare the current check to. As a result, when Medicare Part B premiums need to go up faster than the COLA (which is common), the entire burden of the premium increase goes to the roughly 30% of beneficiaries who aren't covered by the hold harmless rule. That could create a significant financial impact for these beneficiaries.
Coping with low COLA
Retirees need to be prepared for the reality that Social Security benefits will likely continue to shrink compared to the cost of expenses, especially medical expenses. Thus, it's important to save enough to cover at least the core retirement expenses and plan to use Social Security benefits for more frivolous expenses. By designing a retirement budget along these lines, the declining value of Social Security benefits won't affect a retiree's ability to live comfortably.
