Since 1975, Social Security beneficiaries have received annual cost-of-living adjustments (COLAs) tied to a subset of the Consumer Price Index known as the CPI-W, which tracks the price of goods and services across the economy.
Here is how it works: The CPI-W from the third quarter of the current year (the average reading between July and September) is divided by the CPI-W from the third quarter of the prior year. The percent increase becomes the COLA in the next year.
Importantly, COLAs are designed to protect the buying power of Social Security by ensuring benefits increase at the same pace as inflation. For instance, CPI-W inflation increased 2.5% in the third quarter last year, so Social Security payments increased 2.5% this year. That is the smallest COLA since 2021.
Unfortunately, Labor Department data published last week showed CPI-W inflation has reaccelerated in the last three months. That trend is bad news for retired workers on Social Security. Here's why.
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Social Security benefits lost buying power in 2025
The cost-of-living adjustment (COLA) applied to Social Security payments in any given year is based on CPI-W inflation from the third quarter of the previous year. In that sense, COLAs are a reimbursement mechanism to compensate retirees for the buying power benefits lost in the previous year.
That means retired workers are always behind the curve to some degree, but the problem is most severe when inflation is increasing. Put differently, while any inflation reduces the buying power of benefits, Social Security loses buying power most quickly when inflation is trending higher. That is happening today.
Specifically, after falling to 2.2% in September 2024, CPI-W inflation reaccelerated to 2.4%, 2.6%, and 2.8% in October, November, and December, respectively. That means inflation has trended higher in every month since the COLA was calculated. One consequence is that the 2.5% COLA in 2025 underestimated full-year CPI-W inflation of 2.9% in 2024.
That means the spending power of Social Security fell by four-tenths of a percentage point, which is another way of saying the 2025 COLA was not large enough. The shortfall would have a small impact if it were a one-time event, but the same thing happened with the previous COLA. Specifically, CPI-W inflation increased 3.8% in 2023, while benefits only increased 3.2% in 2024.
So, the cumulative COLA in the last two years should have been 6.8%, but benefits only increased 5.8%. For context, the average retired worker received $1,905 per month in December 2023. The monthly payout would now be $2,034, had benefits risen 6.8%, but that retiree gets just $2,015 per month today because benefits only increased 5.8%. The discrepancy totals $228 for the full year.
Importantly, those discrepancies tend to balance out over time because CPI-W inflation in some years falls below the COLA applied to Social Security in the next year. That actually happened with the 2022 and 2023 COLAs. Nevertheless, that inflation is increasing right now is bad news for retirees. And the fact that the full-year CPI-W in 2024 increased more than the 2.5% COLA in 2025 is even worse news. It means Social Security will have a little less spending power this year.
How retired workers can earn additional income in 2025
Retirees looking for extra income have a few good options. The S&P 500 (^GSPC 1.33%) is currently within two percentage points of its record high, which makes today a reasonable time to sell stocks. Alternatively, because interest rates are elevated, several high-yield savings accounts pay very attractive rates. That same applies to money market funds.
Money market funds have an advantage over certificates of deposit (CDs) in that they pay dividends monthly rather than paying interest at maturity. The Vanguard Federal Money Market Fund (VMFXX +0.00%) is a good option. It returned 5.1% in the past year, and similar returns are probable in 2025, given that the Federal Reserve may not cut interest rates this year.
