For many Americans, this has been one of the most challenging years of their lives. The coronavirus pandemic has completely altered our social norms, cost more than 20 million people their jobs, and sent the U.S. economy into its steepest recession in history.

Although retired workers arguably haven't been hit as hard -- financially -- by the pandemic as working Americans, there have nevertheless been concerns raised about how it could adversely affect Social Security's cost-of-living adjustment (COLA) in the upcoming year. With the first of three important data points revealed last week, it's looking as if Social Security's 2021 COLA offers a good news/bad scenario for the program's over 64 million beneficiaries.

Two Social Security cards lying atop and partially covering a one hundred dollar bill.

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A step-by-step of how Social Security's COLA is calculated

However, before digging into the specifics, it's important to understand how Social Security's COLA is calculated each year.

Since 1975, the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) has served as Social Security's inflationary tether. The CPI-W tracks the price movements of a predetermined basket of goods and services, ultimately helping the Social Security Administration determine how much of a "raise" its tens of millions of beneficiaries will receive in the following year to account for inflation.

But not every month factors into Social Security's COLA calculation. The only CPI-W readings that matter are during the third quarter (July through September). Though the U.S. Bureau of Labor Statistics (BLS) will report CPI-W readings each month, the other nine months of the year are simply used to help identify trends.

To determine Social Security's COLA for the following year, the average CPI-W reading from the third quarter of the current year is compared with the average CPI-W reading from the third quarter of the previous year. If this figure has increased from one year to the next, inflation has occurred, and beneficiaries will receive a raise. The amount is simply the year-over-year percentage increase in average Q3 CPI-W readings, rounded to the nearest tenth of a percent.

In 42 of the past 45 years, the average third-quarter CPI-W reading has increased from one year to the next, indicating inflation and an increase for Social Security recipients. In the other three years (2009, 2010, and 2015), deflation occurred, which meant benefits remained flat in the following year (2010, 2011, and 2016). Social Security benefits cannot decline due to deflation. 

Now that you have a better idea of how Social Security's COLA is calculated, let's move on to the meat and potatoes of what's to be expected in 2021.

A senior man counting a stack of cash in his hands.

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The good news: A "raise" now appears likely

For the past couple of months, historic economic weakness tied to COVID-19 and shutdowns of nonessential businesses looked as it if would threaten Social Security's 2021 COLA. The Consumer Price Index for All Urban Consumers (CPI-U), an inflationary measure similar to the CPI-W, registered seasonally adjusted price declines in March, April, and May for its predetermined basket of goods and services.

But there's good news: Inflation is picking back up.

Despite the CPI-U showing an unadjusted 12-month decline (ended July 2020) of 11.2% for all things energy, as well as a 6.5% decline in apparel and 3.7% drop in transportation service costs, the prices of other important expenditures have risen. Food costs, as a whole, are 4.1% over the trailing 12-month period, with shelter and healthcare services up 2.3% and 5.9%, respectively.

The latest BLS inflation report lists the CPI-W reading for July 2020 at 252.636. This is up 0.96% from July 2019, and marks a 0.97% increase from the average CPI-W reading of 250.200 in the third quarter of 2019. Rounding to the nearest whole number, Social Security beneficiaries are currently on pace for a 1% increase in their benefits for 2021. 

Keep in mind that this is just a single month of data, with August and September yet to be factored in. Nonetheless, it's a marked turnaround from where things were headed just two to three months ago.

Scissors cutting a one hundred dollar bill in half.

Image source: Getty Images.

The bad news: Social Security's purchasing power will almost certainly take a hit

Now for that bad news.

Though any positive COLA is better than no COLA at all, a 1% "raise" would represent the second-smallest positive increase over the past 46 years, with only the 0.3% COLA from 2017 being smaller.

You might be thinking that a small COLA isn't that big a deal. After all, the CPI-W is designed to true-up benefits based on the inflation that people are facing.

But the problem is that the CPI-W does a very poor job of measuring the inflation that senior citizens are contending with since it's an inflationary index tracking the spending habits of urban and clerical workers. They are usually not seniors, and they rarely receive Social Security benefits.

In other words, the CPI-W tends to underweight important expenditures for seniors, such as healthcare and shelter, while giving too much weight to costs that just aren't meaningful, like apparel and education. Since the year 2000, this has reduced the purchasing power of Social Security dollars for retired workers by 30%, according to an analysis by The Senior Citizens League.

A 1% COLA in 2021 simply isn't going to do much for Social Security's elderly beneficiaries. Since healthcare and shelter costs account for close to half of all seniors' monthly spending, and prices for these two categories were up 5.9% and 2.3%, respectively, over the trailing 12-month period, a decline in purchasing power for seniors seems like a near-certainty in 2021.