For the vast majority of working Americans, Social Security will play a vital role in their financial well-being during retirement. According to a recent survey from national pollster Gallup, a combined 84% of nonretirees expect to lean on Social Security as a "major" or "minor" source of income in their golden years. This lines up pretty consistently with the 89% of already retired seniors who rely on Social Security income to some degree to make ends meet each month.
Given the importance that Social Security income plays, or will play, for most Americans, there's arguably not a more-anticipated announcement each year than the October cost-of-living adjustment (COLA).
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What is Social Security's cost-of-living adjustment, and how is it calculated?
Without getting too technical, think of Social Security's COLA as the "raise" that's passed along to the program's more than 65 million beneficiaries in most years. You'll note I've put "raise" in quotation marks to represent that this annual payout increase is meant to account for the inflation program recipients have faced and isn't designed to help beneficiaries "get ahead." In simple terms, if the price for goods and services rises, Social Security benefits should, ideally, rise in tandem.
Since 1975, Social Security's inflationary tether has been the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The CPI-W has eight major spending categories and dozens of subcategories, all of which have their own respective percentage weightings. These weightings allow us to measure the price changes for a huge basket of goods and services, yet report it as a single, tidy figure that shows whether inflation (rising prices) or deflation (falling prices) is occurring.
Interestingly, Social Security's COLA is determined using only the CPI-W readings from the third quarter of the current year (July through September) and the third quarter of the previous year. While the other nine months of the year can be helpful in identifying trends, they won't factor into Social Security's cost-of-living adjustment 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, inflation has occurred, and the program's beneficiaries will see their benefits rise come January. The amount of the increase is based on the year-over-year percentage rise in the average third-quarter CPI-W reading, rounded to the nearest tenth of a percent.
Historically high inflation could send Social Security benefits skyrocketing in 2023. US Inflation Rate data by YCharts.
Social Security's 2023 COLA could be huge (but it's nowhere close to a record)
In the upcoming year, Social Security's beneficiaries should see their monthly checks soar. According to Mary Johnson, a Social Security policy analyst at The Senior Citizens League (TSCL), a nonpartisan senior advocacy group, the program's COLA could be as high as 11.4% in 2023 if inflation continues to surge in the third quarter.
By December 2022, I estimate that the average retired worker will be taking home $1,683 a month. An 11.4% COLA would, therefore, translate into a monthly benefit increase of almost $192 come January. In short, the average retired worker could be bringing home up to $1,875 a month come January 2023.
To put this into some context, there have only been two double-digit percentage annual COLAs since the CPI-W became the program's inflationary tether in 1975. In 1981 and 1982, beneficiaries enjoyed 14.3% and 11.2% respective payout hikes. This means the peak forecast from Johnson of an 11.4% COLA would, if accurate, be the second-largest COLA in what I'd call the "modern era" for Social Security.
But when encompassing Social Security's entire history, an 11.4% COLA wouldn't be anywhere close to a record. That's because prior to 1975, cost-of-living adjustments were arbitrarily handed out by special legislative sessions of Congress. Between Jan. 1, 1940, which is when the first monthly benefits began, and 1975, lawmakers voted to increase Social Security's monthly payouts only 11 times. However, the vast majority of these increases entailed double-digit percentage payout hikes.
The biggest COLA for program recipients occurred in September 1950. After beneficiaries went the entirety of the 1940s without an inflationary increase, the Social Security Amendments of 1950 introduced a (drum roll) 77% cost-of-living adjustment to monthly payouts. Suffice it to say, nothing short of hyperinflation will ever dethrone this historic and entirely arbitrary COLA.
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A historically high COLA isn't reason to cheer
In one respect, the prospect of a historically high COLA is probably somewhat exciting for Social Security's tens of millions of recipients. On a nominal-dollar basis, benefit hikes in 2023 should be higher than any year on record.
Unfortunately, not all is what it seems.
For example, if Social Security beneficiaries are readying to receive a historically high boost to their monthly payout, it also means they're contending with historically high inflation. This suggests that a significant portion of 2023's increase to Social Security checks will be gobbled up by higher prices for shelter, food, transportation, and medical care.
What's more, Social Security's inflationary tether has done a poor job of accounting for the inflation that senior citizens are contending with. According to a report from TSCL in May 2022, the purchasing power of Social Security income has declined by an almost unfathomable 40% since 2000. That means what $100 in Social Security income used to buy in 2000 is now only able to purchase $60 worth of those same goods and services.
The issue with the CPI-W, as its official name implies, is that it's focused on the spending habits of urban wage earners and clerical workers. These are typically working-age Americans who aren't receiving a Social Security benefit. More importantly, they spend their money quite differently than seniors. As a result, core expenditures for seniors, such as medical care and housing, are underweighted in the CPI-W. Meanwhile, less important expenses, such as education, apparel, and entertainment, have higher weightings.
Even though lawmakers are well aware of this issue and agree that the CPI-W isn't doing a particularly good job of measuring the inflation that Social Security's seniors are contending with, neither major party has been willing to cede an inch and find common ground with their opponent. In other words, Social Security beneficiaries appear doomed to lose additional purchasing power over time, no matter how robust the COLA is for 2023 and beyond.
