Social Security's importance to our nation's retired workers simply can't be overstated. According to data from the Social Security Administration (SSA) as of April 2018, some 62% of retirees lean on the program for at least half of their monthly income, with slightly more than a third wholly reliant on Social Security for 90% or more of their income. Without this guaranteed monthly payout, the elderly poverty rate likely would be much higher than it is now.
What is COLA and why does it matter?
Because of Social Security's importance to retirees, there arguably is no event more anticipated by current beneficiaries than the annual release of cost-of-living adjustment (COLA) data in mid-October. Think of COLA as the annual "raise" that beneficiaries receive. It's designed to be reflective of the annual inflation that beneficiaries face as a result of the rising price of goods and services.
The inflationary tether currently in use is the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The CPI-W has eight primary spending categories that are examined, with the average reading from the third quarter of the previous year serving as the baseline figure and the average reading from the third quarter of the current year acting as the comparison. If the current-year reading is higher, then beneficiaries will receive a raise in the following year that's commensurate with the year-over-year percentage increase, rounded to the nearest 0.1%. If prices fall year over year, Social Security benefits remain the same from one year to the next.
Obviously, seniors want a healthy COLA each year. Unfortunately, that's not been the case recently. Since 2010, there have been three years where no COLA was passed on to beneficiaries, and in 2017, beneficiaries received a 0.3% raise, which marked the smallest increase in history. This year's 2% COLA actually is the largest increase since 2012.
Seniors are already being shortchanged by the CPI-W
On top of relatively low or nonexistent COLAs, one of the biggest issues retired workers face with COLA is that it may not adequately represent the inflation they're facing.
As noted, the CPI-W takes into account the spending habits of urban and clerical workers -- and working-age Americans tend to spend their money very differently than seniors. In particular, retirees spend a larger percentage on medical care and housing than working-age Americans, but they typically don't see these expenditures accurately reflected in the COLA they receive from one year to the next. In other words, seniors already are losing purchasing power on their COLAs.
An analysis from The Senior Citizens League confirmed this by noting that the purchasing power of Social Security dollars has fallen by 30% since 2000, primarily as a result of the CPI-W not offering an accurate view of the inflation seniors are facing.
Things may get worse
However, things could get even worse for retirees when it comes to COLA. In December, Congress passed the Tax Cuts and Jobs Act, which, among other things, institutes a new inflationary measure for the federal income-tax brackets. Having long used the Consumer Price Index for All Urban Consumers (CPI-U), the Tax Cuts and Jobs Act will switch this tether to the Chained CPI. The Chained CPI is very similar to the CPI-W and CPI-U, save for one big difference -- it takes into account substitution bias.
Imagine this for a moment: You're a shopper in the supermarket and you're perusing the meat department. You notice that the price for steak and other red meat has gone up significantly over the past couple of months, so you decide that, in order to make your budget stretch farther, you'll buy pork and chicken instead of beef. This conscious decision to trade down to a cheaper product perfectly describes substitution bias. The Chained CPI takes into account consumers' desire to substitute for cheaper goods if one good becomes too pricy, while the CPI-W and CPI-U do not.
While the act of trading down to a cheaper product is representative of a genuine consumer reaction to the rising price of goods and services, it also results in a consistently lower inflation reading when compared to the CPI-W and CPI-U. Lawmakers have already implemented the Chained CPI on U.S. federal income tax brackets, so there's the possibility that in the future, lawmakers may choose to use the Chained CPI as Social Security's inflationary tether. Should this happen, COLA would be at risk of growing at an even slower pace than it already is.
To recap: Social Security COLA has been anemic for years, isn't nearly as representative as it should be of the inflation seniors are facing, and is potentially at risk of being reduced in the future by the Chained CPI. Suffice it to say, the erosion of Social Security dollars looks to continue for many more years to come.
The Motley Fool has a disclosure policy.