News about inflation seems to get worse every month, with the most recent report in March indicating that prices of goods and services were up 8.5% year-over-year. This is the largest annual price increase since 1981. The big bump was driven by surging costs for necessities including housing, gas, and food.
Unfortunately, this sky-high inflation is really bad news for retirees. The rapid rise in prices not only erodes the buying power of their savings, but it also demonstrates one really big problem with how Social Security Cost of Living Adjustments (COLAs) are calculated.
There's a major issue with Social Security raises
Social Security COLAs are meant to help ensure retirees don't lose buying power as prices go up.
To measure whether prices are increasing, and by how much, the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) is utilized. This price index measures the costs of a wide variety of goods and services. Social Security's COLA is set based on changes in the CPI-W. For example, if the CPI-W shows prices are up 2% year-over-year, retirees would get a 2% raise.
Only certain months of CPI-W data are used, though. Specifically, the COLA is based on average prices in the third quarter of the year before the raise occurs. So the only relevant months in terms of whether retirees get a raise or not are July, August, and September. To be clear, this means the raise seniors got in 2022 was determined based on how much prices increased year-over-year as measured in July, August, and September of 2021 versus the same months in 2020.
The problem is that inflation has surged since then. As a result, retirees have lost a substantial amount of buying power this year. Retirees received a 5.9% benefits increase in 2022. But with prices currently up 8.5% compared with the same time last year, their benefits increase has fallen far short of keeping up with rising costs.
The fact that the buying power of benefits has eroded so much this year shows the problem that can arise when inflation surges. Since the raise retirees get is based on older data, a rapid increase in prices can lead to serious financial hardships -- especially since the buying power of investment savings also falls when costs go up.
What can retirees do?
The COLA formula simply isn't responsive to surging inflation, and there's nothing retirees can do about the fact that their Social Security raise may be too small when prices rise rapidly after their benefits increase has been calculated for the year.
However, seniors can adjust their budgets to make sure they don't end up in debt or withdrawing too much from their investment accounts when this occurs. The sooner older Americans look for ways to reduce spending as prices go up, the better chance they have at preserving their long-term financial security.
Future retirees should also be aware that COLAs may not actually ensure that retirement benefits don't decline in value, so they should make sure they have plenty of savings to fund a comfortable life even if Social Security falls short.