For more than eight decades, Social Security has been a financial rock for our nation's retired workforce. Today, just over 46 million of the 64.7 million beneficiaries are retired workers, with data from the Social Security Administration showing that 62% of these retirees lean on their payout to account for at least half of their monthly income. 

Given the importance Social Security holds for seniors' wallets, there's arguably not a more anticipated event than the October unveiling of the program's cost-of-living adjustment (COLA). Think of COLA as the "raise" that beneficiaries receive to account for the inflation they're contending with. It's not a raise in the true sense of the word since it's only designed to keep up with the rising price of goods and services. Nevertheless, it means more nominal cash in the pockets of Social Security recipients.

While news on the COLA home front has improved over the past couple of months, the raise that looks to be headed beneficiaries' way in 2021 could be one of the smallest in history.

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

Image source: Getty Images.

It's the most important time of the year for Social Security beneficiaries

As a refresher, the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) has served as the program's annual inflationary tether since 1975. This inflationary index has eight major spending categories and dozens upon dozens of subcategories, each with their own respective weightings. Each month, the Bureau of Labor Statistics (BLS) reports a single CPI-W figure that allows for a clean comparison of whether or not inflation is occurring.

However, the annual COLA calculation for Social Security is derived from a narrow scope of inflation readings. Only the CPI-W readings from the third quarter (July through September) matter when it comes to the upcoming years' COLA. The other nine months can be helpful in identifying trends, but they ultimately have no bearing on whether or not Social Security recipients will receive a raise. That's why we're currently in the most important time of the year for beneficiaries.

If the average CPI-W reading from the third quarter of the current year increases from the average CPI-W reading from the third quarter of the previous year, beneficiaries will receive a raise that's commensurate with the percentage increase, rounded to the nearest tenth of a percent. In 42 of the past 45 years, inflation has been present and recipients have received a bump-up in following-year benefits.

In the uncommon event that the aggregate price of goods and services (as measured by the CPI-W) falls from one year to the next, benefits remain unchanged. Thankfully, Social Security payouts can't decline due to deflation.

A Social Security card wedged between a couple of cash bills.

Image source: Getty Images.

This could be one of the smallest COLAs in history

A couple of months back, during the height of coronavirus disease 2019 (COVID-19) nonessential business shutdowns throughout much of the country, deflation had taken firm hold and it was looking somewhat likely that, for only the fourth time in history, Social Security's beneficiaries wouldn't receive a COLA. But a resurgence of inflation since June has changed the prospects for Social Security's 2021 COLA, albeit not in a meaningful way.

Earlier this month, the BLS reported an August CPI-W reading of 253.597, which is 1.39% higher than the CPI-W reading from August 2019. When averaging the CPI-W readings for the past two months (July and August) and comparing this figure to the average CPI-W reading from the third quarter of the previous year, we reach an increase of 1.16%, which would be rounded to 1.2%. Take note that we're still waiting on the September inflation reading, so this isn't a complete data set, as of yet. 

Assuming we see a continuation of the steady uptick in inflation that's been present over the previous three months, Social Security's 2021 COLA is expected to come in at 1.3% or 1.4%. A 1.3% COLA would tie the second-smallest positive increase since 1975, whereas a 1.4% bump up in COLA would tie for the third-smallest increase in history. 

How much of a payout increase are we talking about? Based on the $1,517.44 that the average retired worker was receiving monthly in August 2020, a 1.3%-1.4% COLA would equate to an extra $20 to $21 a month in pay, or approximately $240 to $250 a year. That's not much of a raise.

A senior couple surprised by the cost of medical bills, with multiple pill bottles on a table in front of them.

Image source: Getty Images.

But wait -- it gets worse

Although any raise is better than what happened in 2010, 2011, and 2016, which is when no COLA was passed along at all, a 1.3% to 1.4% COLA isn't going to do much for retired workers. That's because the purchasing power of Social Security income has been on a pretty steady decline for the past two decades, and it'll almost certainly continue in 2021.

You see, the CPI-W is supposed to provide an accurate measure of the inflation that Social Security beneficiaries are facing. But it does an awful job of this, primarily because it's an index that tracks the spending habits or urban and clerical workers who are often of working age. Senior citizens and working-age Americans spend their money very differently. Important expenditures for seniors, such as medical care services and housing, are receiving less weighting with the CPI-W than they should. At the same time, less-important costs, like education and apparel, receive more weighting. As a result, the purchasing power of Social Security income for seniors has declined by 30% since 2000, according to an analysis by The Senior Citizens League.

Through August, the 12-month unadjusted inflation rate for medical care services was a robust 5.3%, according to BLS data for the Consumer Price Index for all Urban Consumers (CPI-U), a similar inflationary measure to the CPI-W. Meanwhile, shelter inflation came in at 2.3%. Both of these major expenditures for seniors are climbing at a faster clip than next year's estimated COLA.

Beneficiaries should expect a "raise" in 2021, but what they can buy with their Social Security income will once again shrink.