The Sad State of Social Security's Cost-of-Living Adjustments

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Healthcare might be the largest component of the 2016 federal budget, but as a single program Social Security takes the cake. In 2016, $944.3 billion was appropriated for benefit payments, which is around a quarter of the slightly more than $3.8 trillion federal budget. And Social Security is only expected to grow in importance in the years and decades ahead.

As of the May snapshot from the Social Security Administration, 40.6 million retired workers were receiving benefits. This works out to about two-thirds of all Social Security beneficiaries. Gallup's latest poll tells us that about 3 in 5 seniors count on Social Security for a majority of their income during retirement, meaning that somewhere around 24 million seniors are heavily reliant on the program to meet their month-to-month expenses. By 2050, when the elderly population is expected to have nearly doubled to 83.7 million, we could be looking at approximately 50 million seniors reliant on Social Security income, assuming Gallup's poll data remains consistent.

The implication is simple: Social Security needs to remain a solvent and financially healthy program for seniors to count on during retirement. Unfortunately, Social Security could be failing them in two specific ways.

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First, Social Security's long-term financial foundation is an issue. The program itself will remain solvent and continue paying benefits for a long time to come. However, the retirement of baby boomers in increasing numbers means more eligible beneficiaries to strain Social Security. The Social Security and Medicare Boards of Trustees' annual reports, released just two weeks ago, note that the trust funding benefit payments will burn through excess cash reserves of more than $2.8 trillion by 2034. As a worst-case scenario, benefits could be reduced by up to 21% across the board to keep the program solvent through 2090.

Arguably an even bigger issue is the sad state of cost-of-living adjustments, or COLA, for the Social Security program.

The sad state of Social Security's COLA

COLA is the annual "fix" the Social Security Administration applies to paid benefits that's designed to reflect the changing price of a basket of goods and services. Of course, the SSA doesn't simply make up a number and hope everything works out well. It uses the Consumer Price Index for Urban Wage Earners and Clerical Workers, or CPI-W, to help it determine the annual COLA.

The official COLA calculation uses the average CPI-W reading from the third quarter of the previous year as the baseline. In October of the current year, the SSA compares the average third-quarter CPI-W to the baseline reading. The percentage increase between the two represents the COLA that will be passed along to Social Security beneficiaries in the upcoming year. If, by some chance, the CPI-W falls on a year-over-year basis, then no COLA is awarded (i.e., Social Security benefits won't decline from one year to the next based on the CPI-W and COLA).

Here's what the COLA has looked like since 1975.

Data source: Social Security Administration. Chart by author.

You'll note there's no 1983 in the above chart. That's because since 1982 COLAs have been effective with benefits payable for December, but received in January of the following year. Between 1975 and 1982 the SSA had made COLAs effective with benefits payable for June, but received in July.

As you can see, the Social Security COLA has been relatively anemic for the past 20 years, with just five increases totaling 3% or higher. Worse yet, in three of the past seven years retired workers have received absolutely no COLA. In 2010 and 2011 this was a result of economic and pricing weakness following the Great Recession, and in 2016 plummeting crude oil (and thus gasoline) prices were to blame.

This solution could help, but it's far from perfect

If the CPI-W were reflective of the cost needs of seniors, there would be few concerns about relatively small inflationary adjustments. Unfortunately, that may not be the case. Based on data gathered by Forbes that compared the cumulative Consumer Price Index to healthcare cost inflation between 2005 and 2015 (2015's data was through May), healthcare inflation outpaced the CPI by at least 1% in six of those years, including two years where the difference was greater than 3%. As brand-name drug prices soar and surgical-procedure expenses rise, seniors are potentially being denied the income they need to meet these rising costs.

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A proposed solution that could help is switching from the current CPI-W calculation to the CPI-E, or Consumer Price Index for the Elderly. As the name implies, this index tracks the spending habits of adults aged 62 and up. Since Social Security is geared to protect retired workers, it would presumably make sense to reflect their spending habits. Comparing CPI-E data to the CPI-W shows us that seniors spend far more of their money on housing and medical care than do workers. Thus, using the CPI-E as the default COLA gauge could help seniors get more accurate inflationary adjustments from year to year, to cover rising housing and medical care costs.

But there are downsides, too. The CPI-E factors in the spending of far fewer Americans (since most Americans are still working), meaning the CPI-W could be a much more accurate measure of inflation. Also, Medicare Part A expenses aren't factored into the CPI-E, and Part A expenses can be substantial. This means even if the SSA used the CPI-E as its benchmark, medical care inflation might still be underreported.

Protect yourself with this tax-savvy move

Subpar COLA increases mean one thing for all Americans: They need to have a secondary or tertiary source of income during retirement. Benefit cuts in 2034 aside, relying solely on Social Security income simply isn't smart, nor is it potentially feasible given the state of COLA versus healthcare inflation.

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Instead, I would encourage today's working Americans to consider opening or contributing to a Roth IRA. There are a bounty of retirement tools available to workers to encourage them to save and invest, but none, in my opinion, offer the copious rewards of a Roth IRA.

In addition to providing a much-needed source of retirement income beyond Social Security, a Roth IRA allows your money to grow completely tax-free over the life of the account. This means not having to fork over a red cent in taxes during your retirement for distributions, which can come in handy if you're not getting what you need from Social Security alone.

Furthermore, a Roth IRA gives you unheralded financial flexibility. There's no age limit that stops you from making contributions (which isn't true for a Traditional IRA). And, on the flip side, there are no minimum required distributions; if you'd prefer to let your nest egg grow untouched, you can. You'll also have access to the money you've contributed, penalty-free, at any time for any reason, in case you find yourself in a cash pinch.

Everyone should have a plan B available beyond Social Security income. If you don't, then perhaps it's time to start considering a Roth IRA.