Regardless of whether you're currently retired or just entering the workforce, there's a good chance America's most successful social program, Social Security, is going to play a key role in your financial well-being.
According to surveys conducted by national pollster Gallup in April 2021, 85% of nonretirees expect to rely on their Social Security income to some degree to make ends meet during retirement. This compares somewhat similarly to the 89% of polled retirees who were already leaning on Social Security as a "major" or "minor" source of income.
Because of the critical role Social Security will play/is playing for most workers during retirement, arguably no announcement from the Social Security Administration is more closely monitored than the annual cost-of-living adjustment (COLA).
What is Social Security's cost-of-living adjustment and how is it calculated?
In simple terms, COLA is the "raise" that beneficiaries receive most years to account for inflation. If the price for goods and services increases from the previous year, beneficiaries should receive a commensurate benefit hike so they can still afford the same amount of goods and services.
You'll also note I've put "raise" in quotation marks to represent that this isn't a raise in the true sense of the word. Rather, COLA is simply designed to true-up benefits to match the prevailing inflation rate (not help beneficiaries get ahead).
Since 1975, the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) has been the program's inflationary tether. To determine Social Security's COLA for the upcoming year, only CPI-W readings from the third quarter (July through September) are used. The other nine months can be helpful in identifying trends, but they won't factor into Social Security's COLA calculation.
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 in line for a "raise." The amount of the raise is the year-over-year percentage increase in the average Q3 CPI-W reading, rounded to the nearest tenth of a percent.
It all sounds very straightforward, yet things have gone awry.
Social Security beneficiaries have lost 40% of their purchasing power since 2000
Despite there being a clear formula to pass along inflationary benefit hikes, Social Security's COLA has done a poor job of keeping up with the inflation that the average Social Security beneficiary has contended with since the beginning of the century.
According to a new report issued by nonpartisan senior advocacy group The Senior Citizens League (TSCL), the purchasing power of Social Security dollars has declined by a whopping 40% since 2000, as of March 2022.
For added context, the 10-percentage-point loss of purchasing power over the most recent 12-month period (March 2021 to March 2022) is the largest ever recorded by Mary Johnson, a Social Security policy analyst for TSCL. Johnson highlighted a number of rapidly rising costs over the past year that've led to this purchasing power loss, including a 79% increase in home heating oil expenses, as well as certain Medicare premiums and out-of-pocket healthcare costs that aren't part of Social Security's COLA calculation.
Since 2000, the aggregate increase in monthly benefits via COLAs is 64%. This means the average monthly benefit has increased from $816 in 2000 to $1,336.90 by 2022. However, Johnson's study found that a 130% increase in payouts was needed simply to keep up with typical senior expenses. A 130% COLA since 2000 works out to a $1,876.70 monthly benefit. This $539.80 monthly shortfall equates to nearly $6,500 in lost annual purchasing power for the average beneficiary in 22 years.
The COLA calculation is flawed, and there's no easy fix
If you're wondering how it's possible for Social Security to fail tens of millions of seniors so badly, look no further than its inflationary tether, the CPI-W.
As its official name implies, the CPI-W measures the spending habits of urban and clerical workers. The problem is that urban and clerical workers spend their money very differently than senior citizens. For instance, a much larger percentage of seniors' monthly expenditures goes to shelter and medical care costs, relative to working-age Americans. By comparison, the latter spend far more on education, apparel, and transportation than seniors. Because the CPI-W is Social Security's tether, important costs for seniors aren't being given enough weighting, which has resulted in the persistent loss of purchasing power for more than two decades.
Interestingly, lawmakers from both major political parties recognize that the CPI-W is doing a poor job of accurately tracking inflation. However, lawmakers have approached fixing the problem from opposite ends of the political spectrum, and have thus far been unwilling to cede an inch to find common ground with their opposition.
As long as there's no compromise at the congressional level, Social Security will be stuck with the CPI-W as its inflationary tether, and beneficiaries will continue to see the purchasing power of their monthly benefits erode over time.