Retirees have been waiting months for the news that was finally released this morning.
It's the announcement of the 2023 Social Security Cost of Living Adjustment (COLA). This is the periodic benefits increase seniors receive to help ensure they don't lose buying power due to inflation.
So, how big of a COLA are seniors getting? In 2023, Social Security checks will go up by 8.7%. That number may sound impressive. And, indeed, it's the biggest raise in 40 years, outpacing the 5.9% benefits increase in 2022. But, once you dig a little deeper, the news isn't something to be excited about.
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Why an 8.7% raise isn't actually good for seniors
There's a simple reason why a big benefits increase is a problem for seniors. The COLA is calculated based on year-over-year price changes demonstrated by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). Data from the third quarter of the year is analyzed and the percent change in costs determines the amount of extra money seniors will see in their checks for the upcoming year.
In other words, seniors are only getting an 8.7% raise next year because the numbers show the price of a basket of goods and services has increased an average of 8.7% from one year to the next. The raise won't give seniors more buying power -- it's only designed to make sure they won't lose ground.
If Social Security was the only income seniors received, that would mean a big COLA (or a small one) wouldn't really matter. Theoretically, buying power would remain the same despite price changes thanks to the adjustment of their checks. But, that's not the case. Social Security replaces just 40% of pre-retirement income. Most older Americans need additional money, which they get from other sources such as savings and investment accounts.
The problem is, during the periods of high inflation that lead to big COLAs, the money in retirees' savings accounts ends up losing value since interest rates are well below the rate of inflation. And with the huge price surges this year, many retirees with conservative investment portfolios have also seen their investment returns fall below the rate of inflation.
So, while retirees are going to get more money in their Social Security checks next year, this extra cash will go toward covering high prices -- and their spending power from other income sources will be lower. They won't exactly be flush with cash, despite the big raise.
There could be a bright spot, though
Despite this bad news, there's potentially a small bright spot for seniors.
In past years, COLAs haven't even managed to accurately kept pace with the actual inflation seniors have experienced. Some experts believe this is because of the formula used to calculate COLAs. See, the price index used, CPI-W, includes a basket of goods and services designed to mimic the spending of urban wage earners and clerical workers. A different consumer price index, the Consumer Price Index for the Elderly (CPI-E), may be a more accurate reflection of how seniors spend their money.
CPI-E has regularly placed inflation two-tenths of a percentage point higher than the CPI-W measures in the past. This explains why COLAs haven't stopped seniors from falling behind. Recently, however, the reverse has been true. CPI-W has actually measured higher inflation than CPI-E and seniors would have actually ended up with a lower raise if the formula had been changed.
The fact that CPI-W is still used to calculate COLAs is actually good news for retirees now, because it means that their COLA may be higher than the actual inflation they're personally experiencing.
The Federal Reserve is also aggressively raising interest rates to try to reduce inflation, which has many financial experts predicting a recession. If prices actually fall next year due to reduced demand, retirees could find themselves with a COLA that actually goes further than expected.
Of course, retirees can't count on prices falling. It's even possible they'll continue to climb, leaving them much worse off. So, the bottom line is, retirees shouldn't anticipate that a big raise means they can buy more. It's important to continue living on a budget, maintaining a safe withdrawal rate from investment accounts, and using Social Security checks wisely so they cover as many of the basics as they can.
