How Do Social Security Cost-of-Living Adjustments Work?

When the cost of living rises, Social Security benefits are adjusted upward to prevent retirees' benefits from losing purchasing power. Inflation data is evaluated annually for these cost-of-living adjustments, or COLA. Here's an overview of how the COLA process works and whether you'll get a Social Security increase in 2018.

What is a cost-of-living adjustment?

The Social Security COLA is designed to keep retirees' purchasing power constant from year to year. Inflation can vary quite a bit, but has historically averaged around 3% per year. Over long periods of time, this can have the effect of dramatically eroding the purchasing power of money.

For example, let's say that you retire at 65 and begin to receive a $1,400 monthly Social Security benefit. Based on a 3% average inflation rate, that amount of money would only have about $1,030 in purchasing power by the time you're 75 and just $760 when you turn 85. This would require retirees to cut back on their standard of living over time, so the COLA ensures that your Social Security retirement benefit maintains $1,400 in purchasing power in today's dollars, no matter how long you live.

Image source: Getty Images.

How the COLA is determined each year

There are several ways to measure inflation, and most have to do with the Consumer Price Index, or CPI. Specifically, the COLA is based on the annual percentage increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). If this index doesn't increase in a given year, there can be no COLA. And it's also important to mention that if the index declines, meaning that prices have deflated over the past year, there is no such thing as a negative COLA. In other words, your Social Security benefit cannot be reduced due to a decline in the cost of living.

For each year, the CPI-W for the third quarter is compared to the value of the index in the third quarter of the previous year, which is defined as the average of July, August, and September's CPI-W data. For example, the COLA for 2018 will be determined by comparing the third quarter of 2017 to the third quarter of 2016.

If there was no COLA given in a certain year, the CPI-W is compared to the third quarter from the last year for which a COLA was given. For example, there was no COLA given to Social Security beneficiaries for 2016, so the third-quarter CPI-W from 2016 was compared with the third quarter of 2014 in order to determine the COLA for 2017.

Now, the CPI-W is not a perfect index to base the COLA on. As the name implies, the index tracks inflation based on prices of goods that are typically used by working-age people, and is not specifically geared toward retirees. For example, healthcare costs have been rising faster than the CPI-W, and they disproportionately affect senior citizens.

For this reason, there have been discussions of changing the way the COLA is calculated to better reflect expenses that affect seniors, such as a recently introduced bill that proposes using an elderly specific CPI, but for now, the CPI-W is how it's done.

A recent history of COLA

The current system of Social Security COLAs has been in place since 1975. Since then, annual COLA have varied from 0%, which has happened three times, to 14.3% in 1980. Most recently, it was determined in 2016 that Social Security beneficiaries would receive a 0.3% increase to their benefits for 2017.

Here's a history of COLAs from the past decade:

Data source: Social Security Administration.

Will there be a COLA for 2018?

Since we won't know the third quarter's CPI data for some time now, it's impossible to know for sure if your Social Security benefit will increase next year. However, based on the CPI-W data thus far, it looks like there should be a small COLA for 2018.

The third quarter 2016 level for the CPI-W was 235.06 (the number itself isn't terribly relevant to this discussion -- just as a comparison between two points). In April 2017, the most recent month for which data is available, the CPI-W is at a level of 238.43. This implies that even if there is no additional inflation between now and the end of the third quarter, Social Security benefits will get a COLA of about 1.4% in 2018.

Again, the actual 2018 COLA remains to be seen, but now that you know where it comes from, you can keep an eye on the CPI-W (you can keep track on the SSA's website here) to be able to estimate what your COLA might be in 2018 and subsequent years.