Social Security is arguably the country's most important social program. Though that could change in the coming decades as medical care costs rise and Medicare's importance grows, there's simply no program that does more for seniors in retirement than Social Security.

Social Security's pesky inflation issue

Because of its importance to retirees, there's perhaps no event more important than the annual cost-of-living adjustment (COLA) announcement, which comes in mid-October. Think of COLA as the annual raise that beneficiaries receive most years that's designed to keep pace with the rising costs of goods and services (i.e., inflation).

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Social Security's COLA has been measured for more than four decades by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). It takes into account eight major spending categories and should, ideally, pass along a "raise" to eligible beneficiaries that offsets inflation.

Unfortunately, this ideal scenario rarely plays out as expected. Why? The issue is with the CPI-W itself. As its title suggests, it measures the expenditures of urban and clerical workers, who usually have very different spending habits than senior citizens. This results in certain spending categories getting underreported for retired workers, such as medical care and housing, whereas less vital spending categories, such as education, apparel, and transportation, are overrepresented because of the spending habits of working-age urban and clerical workers.

Ultimately, this mismatch between the annual COLA raise and what seniors are actually contending with inflation-wise has led to a significant decline in Social Security's purchasing power since the year 2000. An analysis from The Senior Citizens League finds that the purchasing power of Social Security dollars has declined by 34% in 18 years -- and there's little sign of this pattern abating anytime soon.

This is particularly worrisome given that 62% of current retirees are counting on Social Security to provide at least half of their monthly income.

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The Democrats have a COLA solution

However, Democrats on Capitol Hill believe they have a surefire solution that'll put more money into the pockets of retired workers: switching away from the CPI-W to the CPI-E, or Consumer Price Index for the Elderly.

As the name implies, the CPI-E would specifically focus on the spending habits of households with persons aged 62 and over. Since retired workers make up close to 70% of all existing beneficiaries, it would presumably make a lot of sense to prioritize their spending habits when calculating COLA each year. It should also result in a more accurate COLA reading, and thus a higher annual raise.

A recently released solvency analysis from the Social Security Administration examined this idea, with the assumption that the CPI-E would replace the CPI-W as of December 2020. The result? According to forward-looking projections, seniors would, on average, receive an extra 0.2% in COLA each year. Though that may not sound like much, it would certainly add up over time -- and have the opportunity to become meaningful. It also implies that expenditures like medical care and housing would be more accurately factored into the COLA calculation. 

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...but it comes with a price

However, what you may not realize is that the Democrat's COLA fix could come with an unpleasant surprise for working Americans. Although these higher annual raises don't affect the program's immediate solvency issues -- Social Security is facing the projected exhaustion of $2.9 trillion in asset reserves, and a possible 21% across-the-board cut in benefits by 2034 -- they do increase the long-term (75-year) actuarial deficit by 0.39 to 3.23% from its current level of 2.84%.

In plainer English, the actuarial deficit is the amount that Social Security's 12.4% payroll tax on earned income needs to be increased today in order to not have to cut benefits over the next 75 years. It also assumes that the trust fund ratio -- the amount in asset reserves relative to a select years' expenditures, expressed as a percentage -- would equal 100% by the end of the long-term forecast. In essence, by 2092, the program would have enough excess cash to completely cover outgoing expenditures for a year.

In 2018, the Trustees have estimated that a 2.84% increase to the existing payroll tax would be needed to compensate for an expected $13.2 trillion cash shortfall between 2034 and 2092. This would push the aggregate payroll tax to 15.24% (12.4% plus 2.84%). If there is a silver lining here, it's that most workers only pay half of this amount. If you're employed by someone else or a corporation, your employer covers half of your Social Security responsibility, which in this case would be 7.62%, up from the current 6.2%. The self-employed get stuck footing the full tax.

Yet, if Democrats were to switch to the CPI-E from the CPI-W, the projection suggests that an additional 0.39% tax would be needed over the long term to cover these higher COLAs. That's an extra 0.195% of wage income out of the pockets of every working American employed by someone else, or 0.39% for the self-employed. For the average worker earning about $30,000 a year, we're talking about an added $58.50 in payroll tax, or $117 extra annually for the self-employed. Over time, these payroll taxes could certainly add up.

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The Republican plan has a drawback, too

Clearly, the Democrats' plan isn't perfect. Switching to the CPI-E would probably wind up hitting all income classes with a higher payroll tax. But the Republicans' COLA proposal has its drawbacks, too.

The GOP solution involves switching from the CPI-W to a measure known as the Chained CPI. This is the same inflationary measure Republicans instituted on federal income tax brackets and numerous deductions and credits when the Tax Cuts and Jobs Act was passed in December.

The Chained CPI and CPI-W are a lot alike, but with one substantial difference: substitution bias. This is where consumers consciously trade down from a pricier good to a similar but less expensive good. Neither the CPI-W nor CPI-E consider substitution bias in their calculations, but the Chained CPI does. As a result, COLAs tend to be notably lower on an annual basis. Though such a move could save Social Security money over the long run, it could also, according to The Senior Citizens League, reduce annual payouts from the program by nearly $2,100 a year if we were to, hypothetically, look 30 years down the road. 

There are pretty much two truths when it comes to Social Security and its COLA. First, the program's current payout schedule is unsustainable, and second, no matter what pathway lawmakers take to fix the program, someone is going to lose. The big questions are: How long do we have to wait for that fix, and who'll wind up losing?

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