In 2022, retirees got the biggest Social Security cost of living adjustment (COLA) in four decades. Next year, the benefit increase could be even larger than the one seniors got this year. This may seem like a good thing. But it's not.
To understand why a bigger raise doesn't help seniors financially -- and could actually hurt them -- it's helpful to learn about the truth about COLAs.
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What next year's Social Security raise could look like
In 2022, Social Security retirees received a 5.9% increase to their benefits. This was well above the raises seniors had been eligible for over the past several decades. In fact, the benefits bump hasn't been above 3% since 2012, and it hasn't exceeded 5% since 2009.
While that COLA may have seemed large at the time, the 2023 increase will most likely be even bigger. The chief actuary of the Social Security Administration has projected around an 8% raise. That's a 35.6% larger bump up in benefits than retirees experienced during this past year.
A 36% annual increase in the size of Social Security's COLA could have serious consequences
A huge COLA will undoubtedly give retirees more money -- on paper. But it is actually terrible news, even though it makes it appear household income is going up. That's because COLAs are based on only one thing: inflation. Inflation is the rising cost of goods and services. It happens naturally over time, which is exactly why there are periodic Social Security benefits increases in the first place.
The Federal Reserve's target rate of inflation is 2%, which means the goal is to have prices rise slowly. And that's mostly been what has been happening in recent years, which is why Social Security's COLAs haven't been very high. Recently, inflation has been surging, though, with prices up 8.6% in May compared with the prior year. It is this record-high inflation that has resulted in seniors being on schedule to receive a big Social Security raise next year.
Unfortunately, the huge increase in prices -- which is heavily influenced by big jumps in the cost of energy and groceries -- means that retirees will be in a worse position next year even with the COLA. Since Social Security replaces only about 40% of preretirement income, most retirees get some money from other sources as well. Most often, the extra funds they need come from an investment account. And because retirees need to invest conservatively because they cannot afford to wait for a recovery if the market crashes, chances are good they aren't earning 8.6% annual returns on their investment.
This means if retirees take out 8.6% more from their savings next year so they can maintain the same buying power, they will end up with their principal balance going down by much more than normal. And this increases the risk of running out of money. Their other option would be to cut their spending by 8.6%, which isn't going to be easy at a time when prices are going up on necessities.
And the Federal Reserve is aggressively raising interest rates to try to curb inflation, which increases the risk of a recession and means that any retiree with variable-rate debt will likely have to pay more for it.
For all these reasons, seniors shouldn't get excited about the possibility of a raise that's 36% bigger than last year's COLA because it means that the rate of inflation has increased substantially over the past year. Retirees must make a financial plan to cope with this potentially damaging reality.
