For Social Security beneficiaries, and especially retired workers, there's one event every year that stands head and shoulders above the rest: the Social Security Administration's (SSA's) October announcement of the upcoming year's cost-of-living adjustment (COLA).

Social Security's COLA lets the program's 64 million beneficiaries know how much extra money they'll be receiving each month in the upcoming year. Keep in mind, though, that this increase isn't a "raise" in the true sense of the word, so much as a nominal increase that's designed to keep up with the inflation that program recipients are contending with.

A senior man counting a fanned pile of cash in his hands.

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Here's how the SSA calculates your cost-of-living adjustment every year

Since 1975, the Consumer Price Index for Wage Earners and Clerical Workers (CPI-W) has been Social Security's inflationary tether. The CPI-W has eight major spending categories, as well as dozens upon dozens of subcategories, all of which have respective weightings. This predetermined basket of goods and services allows the Bureau of Labor Statistics (BLS) a means of measuring inflation, which can be expressed in a single number. The SSA then utilizes this BLS data to calculate COLA.

For the purposes of calculating COLA for Social Security, only data from the third quarter (July through September) is taken into consideration. That means that while the CPI-W readings from the other nine months of the year can help identify inflationary or deflationary trends, their data points aren't used in the final calculation to determine COLA in the following year.

To calculate COLA, the SSA compares the average CPI-W reading from the third quarter of the previous year to the average CPI-W reading from the third quarter of the current year. If it's risen from the previous year to the current year, then beneficiaries will receive a "raise" that's commensurate with the percentage increase, rounded to the nearest tenth of one percent. Meanwhile, if deflation occurs and prices fall, benefits remain static from one year to the next. Thankfully, deflation cannot lead to a decline in Social Security payouts.

A Social Security card wedged in between fanned cash bills.

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A way-too-early look at Social Security's 2021 COLA

Given that we're still more than five months away from even reaching the first month (July) where the data becomes truly meaningful, no concrete takeaways can be made about Social Security's COLA for next year. However, certain trends do shed light on what the program's 64 million beneficiaries might expect come 2021.

For example, you might be surprised to learn that trailing 12-month inflation rates (not seasonally adjusted) for the CPI-W came in at 2.3% in December. That's the highest trailing 12-month inflation reading since October 2018. As some of you might remember, last year's COLA (derived CPI-W readings in the third-quarter of 2018) of 2.8% was the highest in seven years. While readings above 2% can be fleeting, more often than not a reading above 2% over the past decade has led to numerous subsequent months of trailing inflation readings also above 2%. Translation: Things right now would suggest that the 2021 COLA would be higher than the 1.6% COLA passed along in 2020, albeit a lot could still change. 

What's driving this higher level of inflation, you ask? A quick look at the Consumer Price Index for All Urban Consumers (CPI-U), a similar measure of inflation to the CPI-W, shows a reversal for energy prices. Whereas West Texas Intermediate crude prices fell in the third quarter of 2019, relative to the third quarter of 2018, thereby pushing gas prices and fuel oil costs down, WTI crude prices have notably risen in recent months. Furthermore, medical care services and shelter inflation are chugging along at 5.1% and 3.2% over the 12 months, ended December 2019. 

A visibly worried senior holding a coffee cup while a stack of bills sits on the table in front of him.

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The dark side of Social Security's COLA

While a bigger COLA than the 1.6% "raise" that was passed along in 2020 probably sounds great, it's important to realize that there's more to COLA than meets the eye.

For one, a higher COLA isn't necessarily a good thing. Sure, it leads to a larger nominal increase in beneficiaries' monthly paychecks from Social Security. However, it also signifies that beneficiaries are facing a higher level of inflation, as a whole. Social Security's COLA was never designed to help its recipients get ahead. Rather, it's only there to ensure they keep up with the rising price of goods and services over time.

Second, it's important to realize that Social Security's inflationary tether, the CPI-W, is inherently flawed. As its official name suggests, it's a measure focused on the spending habits of urban and clerical workers. News flash: Most urban and clerical workers are of working age, and are not receiving a Social Security benefit. Meanwhile, more than 80% of Social Security beneficiaries are seniors. In other words, the CPI-W isn't doing a good job of properly accounting for the inflation that seniors are contending with. It often results in medical care and housing expenditures getting less weight than they deserve, while lesser-important costs, such as apparel, education, and transportation, receiving higher weightings.

According to an analysis from The Senior Citizens League, the CPI-W has caused seniors to lose 18% of their Social Security income purchasing power over the past decade, and 33% since the year 2000. The point being that no matter what COLA is eventually passed along in 2021, it's not going to make up for what's been lost over just the past two decades for seniors.