What the Social Security COLA Means for You

Nearly one in every four retirement-age Americans lives in a household that derives more than 90% of its income from Social Security benefits, making it an integral part of the modern retirement plan.

These benefits are the bedrock of so many retirement plans because the checks always cash, and the Social Security Administration (SSA) also has a mechanism in place to ensure that benefits keep up with the rising cost of living throughout retirement. Over time, benefits are designed to increase to keep pace with rising prices experienced by urban wage earners (low- and middle-income workers) by way of an annual cost of living adjustment (COLA).

However, things could change. There has been a lot of chatter about altering the way COLAs are calculated, which could mean reduced benefits for the 68 million Americans currently receiving benefits, as well as every American who will receive Social Security in the future. 

Below, we'll explain everything you need to know about Social Security COLAs, how they're calculated, and how proposed changes could affect what you receive every month. But first, let's start at the beginning.

Image source: Getty Images.

What is a COLA?

COLA stands for "cost of living adjustment." The whole purpose of COLA is to ensure that you'll be able to buy as much with a Social Security check you received in 2018 as the one you'll receive in 2028 or 2038. 

Thanks to inflation, the prices of goods and services we purchase tend to go up over time. A Hershey bar that cost $0.10 in 1970 is now rarely sold for less than $1 on store shelves. A gallon of gasoline, which cost as little as $1 per gallon 20 years ago, now retails for close to $3 per gallon in most of the United States.

Of course, the cost of some goods goes down thanks to technological improvements (television sets being a perfect example), but on average, the things we need to sustain our day-to-day lives will cost more in the future than they do right now.

If Social Security weren't adjusted for the rising cost of living, recipients would find that their checks bought less goods and services with each passing year. For example, by one measure, the value of the dollar has declined by about one-third since the year 2000. Thus, a retiree who began collecting benefits in the year 2000 would only be able to buy about two-thirds as much with his or her benefits in 2018.

Inflation is an omnipresent risk to a retiree's financial picture. Considering that someone who retires at full retirement age (67 years old for most people) could reasonably expect to receive benefits for 20 years or more, adjusting for the annual changes in the cost of living is very important for beneficiaries.

History of COLA

Social Security was created in 1935 as a response to the Great Depression, when as many as 50% of senior citizens were living in poverty, and 25% of working-age adults were out of work. By providing regular income to retirees, political leaders believed a "social insurance" program could give retirees economic security in old age. As a side benefit, Social Security was expected to "nudge" some workers into retirement, thus opening up jobs for the unemployed.

The first monthly Social Security benefits were paid in January 1940, but over the course of the next decade, it became clear that the program had an obvious flaw: Prices were increasing, but benefits were not. In 1950, Congress decided it needed to increase benefits, resulting in a 77% cost of living adjustment, the largest ever. 

You see, prior to 1975, Social Security benefits were only increased when Congress voted to increase them. As you can imagine, this made the process especially political, particularly as a larger number of retirees began collecting old age benefits. 

More importantly, without automatic adjustments, inflation whittled away benefits for years until another increase was approved. From 1950 to 1975, Congress increased benefits only 10 times, resulting in multiyear waits for the next adjustment, even though the cost of living was rising by the year, if not by the month or day.

Data source: Social Security Administration. Chart by author.

Things changed in 1975, when the first automatic annual increases took effect. The timing was no accident: The United States was experiencing elevated inflation, and thus retirees could quickly see their purchasing power eroding.

Inflation soared in the late 1970s and 1980s, rising as high as 15% year over year in April 1980. But because benefits increased in line with the change in prices, a Social Security check disbursed in 1985 bought just as much as a check mailed in 1975.

Since 1975, Social Security benefits have been increased in all but three years. In 2010, 2011, and 2015, the Social Security Administration announced that there would be no cost of living adjustments for benefits paid during the following years. More on that later...

How Social Security COLA works

To make COLAs automatic, Congress had to design them to be formulaic. The Bureau of Labor Statistics (BLS) does most of the heavy lifting. Specifically, the BLS publishes a measure of inflation known as the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), which the Social Security Administration uses in its COLA calculations.

To determine CPI-W, the BLS samples prices for just about everything from food, shelter, clothing, gas, transportation, drugs, and doctors' and dentists' bills, among many other goods and services that households purchase or consume with regularity. This inflation measure tracks the changes in consumer prices for goods and services based on the estimated spending patterns of urban wage and clerical workers -- in other words, low- and middle-class workers. 

Prices are collected from approximately 22,000 different retail establishments. Housing costs are measured by sampling 5,000 different housing units. The prices from 75 different urban areas are pieced together and averaged, with the goal of creating an index that accurately tracks the average changes in monthly expenditures for a large swath of the American population.

After the BLS has done the hard work by calculating CPI-W, the Social Security Administration just has to do some basic math. It determines COLAs by calculating the change in CPI-W from the third quarter of one year to the third quarter of the next year. So, if CPI-W averaged 200 and 210 in the year after, the 5% increase in CPI-W would result in a 5% cost of living adjustment to Social Security benefits.

The cost of living adjustment amount is announced in October and takes effect for payments made the following year. For example, a 2% COLA was announced in October 2017, but the increased payments did not take effect until January 2018 (benefits for January are actually disbursed in December due to holidays).

The nitty gritty of COLA math

Below, we'll get into the nitty-gritty of how annual cost of living adjustments are calculated, and how they affect your benefits down to the nearest dollar. If you're not interested in the mathematical details, or don't care to figure out next years' benefits down to the dollar, scroll on down to the heading entitled "COLA criticisms and controversies."

The math behind cost of living adjustments is relatively straightforward, but you have to know where to look to find the relevant data. We'll start first with the CPI-W index data reported by the Social Security Administration, which we can use to calculate how it arrived at a 2% COLA for benefits paid in 2018. 

The relevant data is included in the table below.

Dsta source: Social Security Administration.

First, we simply need to find the average COLA for the third quarter of 2016 and 2017, respectively. We do that by adding up all the figures for each month, and dividing the sum by three. 

Thus, for 2016, the math is as follows:

(234.771 + 234.904 + 239.448) / 3 = 235.057

The same calculation is repeated for 2017, resulting in a figure of 239.668.

With an average CPI-W for the third quarter of 2016 and 2017, all we need to do is divide the most recent year's figure (239.668) by the figure for the previous year (235.057) and subtract 1.

(239.668 / 235.057) - 1 = .0196, or 1.96%

We're not done just yet. Importantly, cost of living adjustments are rounded to the nearest tenth of one percent. Thus, 1.96% would round up to a flat 2% COLA increase for benefits paid in the following year (2018).

How COLA affects your benefits

Figuring out how each COLA affects your benefits requires a little more multiplication and rounding. That's because the COLA is applied to your primary insurance amount (PIA), which is rarely exactly equal to the amount of benefits you receive each month. (The best way to find your PIA is to log in to your Social Security account online.)

For the sake of example, let's assume that in 2017, your primary insurance amount was $1,514 per month. To adjust for the 2% COLA, we multiply this figure by 1.02.

$1,154 × 1.02 = $1,544.28

Benefits are truncated down to the dime. In other words, they are always rounded down to the dime. Thus, a PIA of $1,544.28 would be truncated to $1,544.20 per month.

From there, the new $1,544.20 primary insurance amount is multiplied by a factor to adjust for when you retired. For example, if you were born in 1957 and retired at 65 years of age, this factor is 90%, which reflects the 10% reduction in benefits for retiring before full retirement age. (You can use this table from the SSA to determine which factor applies to you.)

$1,544.20 × 0.9 = $1,389.78

Any offsets are subtracted from the benefit amount of $1,389.78. (Common offsets include amounts deducted for Supplementary Medical Insurance premiums, or a Government Pension Offset.)

After subtracting these offsets, the benefit amount is truncated to the nearest dollar. So, assuming no offsets, the monthly benefit of $1,389.78 would be rounded down to $1,389.00 per month. And with that, we're done!

COLA criticisms and controversies

Cost of living adjustments for Social Security have, at times, been a hot-button political issue. One of the biggest points of contention is whether the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) is an appropriate index for measuring the change in the cost of living.

As the BLS's first published measure of inflation, CPI-W was designed to track the changes in consumer prices as experienced by low- and middle-income Americans who derive more than half of their earnings from wage or clerical work for at least 37 weeks per year.

Notably, because it focuses on the roughly 29% of Americans who fit the above description, it isn't designed to conform to the purchase patterns of part-time or salaried workers, those employed in professional careers, the self-employed, or, most importantly, retirees.

Image source: Getty Images.

Ignoring the purchases of retirees opens CPI-W to easy criticism. Compared to the typical retiree, a working wage-earner is likely to spend more on transportation, and less on healthcare expenditures, for example. Thus, it's possible that CPI-W may over or understate the inflation rate as experienced by America's retired population in any given year. 

Replacing CPI-W with a measure of inflation that more accurately tracks inflation as seniors experience it has been proposed time and time again. Many people have suggested using CPI-E, an experimental measure of inflation that tracks the expenses of the elderly, in place of CPI-W.

If CPI-E were used to determine cost of living adjustments, the net effect is that COLAs would be about 0.3 percentage points higher, on average. So far, though, efforts to switch to CPI-E haven't gotten very far, since Social Security is already cash-flow-negative (benefits paid exceed revenue generated from associated taxes), and the prevailing view is that Social Security benefits are likely to be decreased rather than increased.

A cost of living adjustment is not guaranteed

In recent years, the decline of inflation (and the resulting decline in COLAs) has led to some controversy, particularly in the years following the Financial Crisis of 2008. For the first time ever since 1975, the Social Security Administration announced in 2009 that there would be no COLA to benefits paid in the following year. This is because consumer prices as measured by CPI-W actually decreased from 2008 to 2009, primarily because the spike in energy prices in late 2008 was short-lived.

A 0% COLA in 2010 resulted in widespread outrage as American retirees who had become accustomed to annual increases in their Social Security benefits came to expect that increases were a fact of life, not something tied to an index that, until then, few people cared about.

In truth, retirees actually received more than they bargained for, as consumer prices dropped, on average, from 2008 to 2009. The law does not allow for a negative COLA, so benefits were held flat, meaning that benefits provided for more purchasing power in 2010 than they did in 2009, since prices dropped, but benefits paid did not.

Data source: Social Security Administration. Calculations by author. The average shown in the table above is the geometric mean. For example, from 1975 to 1984, COLA increases resulted in a 101% increase in benefits. For benefits to roughly double in 10 years, benefits had to increase at a compounded average annual rate of 7.2%.

The following year, in 2010, the SSA again announced a 0% COLA for benefits paid in 2011. This is because the average reading for CPI-W in the third quarter of 2010 was still lower than the CPI-W reading for 2008. (COLA increases only happen when CPI-W readings are higher than the last high water mark, so, in 2010, the CPI-W in the third quarter of 2010 was compared to the CPI-W in the third quarter of 2008.)

Putting individual circumstances aside, the point of cost of living increases is to ensure that benefits keep pace with inflation. Mathematically, if benefits are increased 5% due to 5% inflation, Social Security recipients are no better off than if benefits are increased by 0% due to 0% inflation.

Of course, it's not hard to see why people feel better off getting a 5% "raise" even if prices increase by 5%. Changes in benefits are easy to see and measure; changes in the average level of prices are not so easily observed.

Still, in more years than not, benefits have been increased. Since automatic COLAs were implemented in 1975, the Social Security Administration has only announced 0% COLAs in three years (2009, 2010, and 2015) for benefits paid in 2010, 2011, and 2016.

Replacing CPI-W with Chained CPI

Occasionally, political leaders consider changing the method for calculating cost of living adjustments. A common proposal is replacing CPI-W with "chained CPI" as a reference for inflation. This is highly controversial, particularly because it is typically proposed as a thinly veiled way to reduce benefits paid out in the future.

The big difference between chained CPI and CPI-W is that chained CPI assumes that if prices for a particular good or service rise or fall, consumers will save money by substitution. A common example is that if the price of Honeycrisp apples increases, consumers may opt for less-expensive Red Delicious apples instead. Because of these substitutions, chained CPI tends to increase at a lower rate than CPI-W.

Data from BLS. Chart by author.

The differences between the chained CPI and CPI-W are small from year to year, amounting to about 0.3 percentage points on average. However, over a period of 10 or even 20 years, there is no such thing as a rounding error -- over a full retirement, 0.3 percentage points, compounded annually, make a big difference.

This is, by far, one of the most pressing issues as it relates to Social Security cost of living adjustments today. Replacing CPI-W with chained CPI has been brought up time and time again, most recently when Congress was looking for ways to pay for the Tax Cuts and Jobs Act of 2017. (Chained CPI was introduced in some parts of the Tax Cuts and Jobs Act, but not those relating to Social Security COLAs.) Before that, in 2013, then-President Barack Obama suggested switching to chained CPI when he proposed his budget for 2014. 

You can bet that chained CPI will reappear in the future because the sheer size of Social Security payments means that even a modest reduction in benefits results in big savings. When the Congressional Budget Office studied the effect of switching to chained CPI in 2014, it estimated that the savings would tally to roughly $127 billion over 10 years. Over longer periods of time, the savings only grow larger thanks to the power of compounding.

Could the methodology for calculating COLAs change in the future? It's possible, though it seems unlikely. Given more than 15% of America's population is 65 years old or older, and many more baby boomers are on the cusp of reaching retirement age in the next decade, tinkering with Social Security benefits is a risk few politicians are willing to take...yet.