Each month, Social Security divvies out a benefit check to 63 million people, of whom approximately 70% are retired workers. Of these retirees, 62% lean on their benefit to account for at least half of their monthly income, and just over a third rely on Social Security for essentially all of their income (90%-plus). Given this data, there's probably no event that's more closely monitored each year by beneficiaries than the mid-October cost-of-living adjustment (COLA) announcement.
Think of COLA as the "raise" that beneficiaries receive from one year to the next as a result of the inflation (the rising price of goods and services) that they've encountered. This year, recipients are enjoying their largest COLA in seven years -- a 2.8% increase.
But what most folks probably don't understand is how Social Security determines COLA each year. Let's walk through the COLA calculation process on a step-by-step basis.
Step 1: Choose the right inflationary tether
In order to calculate Social Security's COLA, you'll first need to know which inflationary measure (published by the U.S. Bureau of Labor Statistics, or BLS) to use. In this instance, it's the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). Former President Richard Nixon signed the Amendments of 1972 into law, allowing COLA to be adjusted annually according to changes in the CPI-W, beginning in 1975.
The CPI-W itself has a number of major spending categories, with dozens upon dozens of subcategories, each with their own respective weightings (shelter costs having the largest individual weighting) -- the purpose being to measure the year-over-year change in price for each subcategory, major category, and the CPI-W index as a whole.
Step 2: Locate the only months of importance
Despite the BLS reporting monthly readings for the CPI-W, most of these readings will prove meaningless in calculating COLA. The only months that factor into the COLA calculation are those in the third quarter -- July, August, and September. The other nine months, while perhaps statistically intriguing and meaningful for other indexes, have no bearing on Social Security's COLA.
It's also worth noting here that the BLS reports previous-month data during the second week of the following month (e.g., July's CPI-W data comes out during the second week of August). This is why it takes until the second week of October to concretely figure out what the upcoming year's COLA will be.
Step 3: Determine your baseline reading from the third quarter of the previous year
Once you've located the data you'll need, the next step is to determine the baseline CPI-W reading from the previous year. This is just a fancy way of saying that we'll take the CPI-W readings from July, August, and September, add them up, then divide this totaled figure by three to get an average third-quarter reading from the previous year.
As an example, here are the CPI-W readings from the three meaningful months in 2017:
- July 2017 CPI-W: 238.617
- August 2017 CPI-W: 239.448
- September 2017 CPI-W: 240.939
If we add these figures up and then divide that larger figure by three, we're left with an average third-quarter CPI-W reading of 239.668 in 2017. That's our baseline number.
Step 4: Calculate the current-year average CPI-W reading for the third quarter
Now that we have the baseline figure, it's time to calculate the current-year average reading, which will be used as the comparison figure. Again, using the three months that matter, here are the CPI-W readings for 2018 from the BLS:
- July 2018 CPI-W: 246.155
- August 2018 CPI-W: 246.336
- September 2018 CPI-W: 246.565
If these three figures are added together and subsequently divided by three, we're left with an average third-quarter reading for the CPI-W in 2018 of 246.352.
Step 5: Compare the figures
Here's where things get exciting. The next step is to put both figures side by side.
If the current-year average reading is lower than the previous year's average reading, it would imply that the average price for goods and services, as measured by the CPI-W, has fallen year over year. We refer to this as "deflation." If this were to happen -- and it's happened only three times since the CPI-W began measuring inflation in 1975 -- benefits would remain the same from one year to the next. Essentially, there would be no COLA, which is what happened in 2010, 2011, and 2016. Benefits, thankfully, can't fall as a result of deflation.
In our example above, 246.352 is a larger number than 239.668, which means the price of goods and services measured by the CPI-W rose year over year. This inflation means there will be a positive COLA in the following year, and beneficiaries will receive a "raise."
Step 6: Calculating the size of next year's COLA
Now that we know COLA will be positive, let's put the finishing touches on determining how big the raise will be.
The first thing we need to do is establish the difference in the year-over-year readings. We do that by subtracting the 2017 average CPI-W reading (239.668) from the current-year reading (246.352). Doing so leaves us with 6.684.
Now, take this difference of 6.684 and divide it into the average CPI-W reading from the third quarter of the previous year (239.668). Multiply the result by 100, and you're left with a percentage increase in the average CPI-W reading from the previous year. In the above example, the result is 2.789%.
Step 7: Time to round your result up or down
The final thing you'll need to do is round your result to the nearest 0.1%. Since 2.789% is closer to 2.8% than 2.7%, the resulting calculation pushes the COLA for the upcoming year to 2.8%.
In other words, you don't have to be a calculus professor to stay abreast on the latest COLA developments. Simply keep track of the all-important CPI-W readings from the BLS during the third quarter, and you'll be well ahead of the curve in knowing what to expect in the upcoming year.