Whether you realize it or not, Social Security is, or will likely be, a vital income source during retirement. It's responsible for pulling nearly 22.5 million people out of poverty every year, and close to 90% of retired workers lean on their monthly payout, to some degree, to make ends meet. 

With Social Security playing such a critical role in the financial well-being of current and future aged Americans, there's arguably no announcement more anticipated each year than the cost-of-living adjustment (COLA).

A smiling person holding up a fanned assortment of cash bills.

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What is Social Security's COLA, and what does it mean for your monthly payout?

Think of COLA as the "raise" that Social Security's more than 65 million beneficiaries receive most years to account for inflation -- the rising price of goods and services. You'll note that "raise" is in quotation marks to reflect that this benefit hike has everything to do with truing up payouts to match inflation and nothing to do with helping beneficiaries outpace the prevailing inflation rate.

Since 1975, the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) has served as Social Security's inflationary measure. Although the CPI-W has eight major spending categories, there are dozens upon dozens of subcategories, each with their own respective percentage weightings. These weightings allow for the CPI-W to be expressed as a single number, which makes for easy month-to-month and year-to-year comparisons when examining price changes for goods and services.

For Social Security recipients, there is no time more important than now. That's because only CPI-W readings from the third quarter (July through September) factor into the program's COLA calculation. While the other nine months of the year can provide helpful trends, those CPI-W readings have absolutely no effect on Social Security's COLA in the upcoming year.

To calculate COLA in the upcoming year, the average CPI-W reading from the third quarter (Q3) of the current year is compared to the average CPI-W reading from Q3 of the previous year. If it's risen, beneficiaries will see their Social Security checks rise in the upcoming year by the percentage increase, rounded to the nearest tenth of a percent.

Chart showing the U.S. inflation rate going up sharply since 2020.

Historically high inflation could send Social Security's COLA for 2023 to a greater than four-decade high. U.S. Inflation Rate data by YCharts.

Social Security checks are on pace for their biggest increase in decades

Last week, on Aug. 10, 2022, the U.S. Bureau of Labor Statistics lifted the veil on July's inflation data (the first meaningful month for Social Security's cost-of-living calculation). For the month, the CPI-W came in at 292.219.

Keeping in mind that there are still two readings needed (August and September) before Social Security's COLA can be concretely calculated, the initial July CPI-W portends one of the biggest increases to Social Security checks in more than four decades. The July reading of 292.219 is 8.9% (rounded) higher than the average CPI-W reading during the third quarter of 2021 of 268.421. 

What, exactly, would an 8.9% cost-of-living adjustment look like in the average retired worker's benefit check? As of June 2022, 47.9 million retired workers were bringing home an average of $1,669.44 per month. This average monthly payout tends to rise by about $2 a month, which reflects newer retirees entering the benefit pool. Thus, by December, the average retired worker should be receiving approximately $1,683/month.

Based solely on the July CPI-W reading, relative to the third-quarter average CPI-W reading from 2021, an 8.9% COLA on top of $1,683 would boost monthly benefits for the average retired worker by a hearty $149.79, or close to $1,800 a year, in 2023. With inflation raging to four-decade highs, I can only imagine that a $150 per month increase in Social Security checks would be welcomed with open arms.

Visibly worried person resting their chin on their fist.

Image source: Getty Images.

A historic COLA comes with consequences

Unfortunately, the largest nominal-dollar monthly increase to Social Security checks in history isn't without its consequences. Although more than 65 million beneficiaries stand to receive a healthy uptick in their monthly payout in 2023, two significant headwinds stand in their way.

To begin with, a significant portion of Social Security's 2023 cost-of-living adjustment could be eaten up by inflation. After all, COLA is designed to keep Social Security checks on par with the rising price of goods and services. Significant jumps in fuel, food, and shelter costs over the past year, and moving forward, could chip away at most, or all, of the 8.9% COLA that the program is currently pacing (through July) for the upcoming year. And this isn't even the biggest worry.

According to a report released by nonpartisan senior advocacy group The Senior Citizens League, the purchasing power of Social Security income has declined by 40% since 2000. In easy-to-understand terms, what $100 in Social Security income used to buy in 2000 now only buys about $60 worth of those same goods and services in 2022.

The issue with Social Security's COLA is that the CPI-W does a poor job of accounting for the inflation that seniors are contending with. That's a problem, because senior citizens comprise the lion's share of Social Security recipients.

As the CPI-W's full name implies, it's an inflationary tether designed to track the spending habits of urban wage earners and clerical workers. These are typically working-age Americans who aren't receiving a Social Security benefit. In short, they spend their money very differently than senior citizens. As a result, important expenditures for retirees, such as shelter and medical care, are underweighted in the CPI-W, while less important costs, such as apparel, education, and transportation, have higher weightings.

With no fix to Social Security's COLA calculation on the horizon, retired workers are liable to continue losing purchasing power over time.