What Are Social Security COLAs and How Do They Work?

Social Security is the U.S. government program that distributes retirement, disability, and survivors' benefits, and it's a great source of income for retirees for many reasons. For one thing, benefits go up periodically to keep pace with rising prices. These increases to Social Security benefits are called "cost-of-living adjustments," or COLAs. Cost-of-living adjustments occur each year that there's an increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

These increases are usually relatively small; in some years they're nonexistent. There are also circumstances where there is a COLA adjustment but benefits don't actually go up, because of increases in Medicare premiums deducted from Social Security checks. Still, COLAs aim to protect the buying power of seniors, so it's important to understand how they work.

This guide will explain everything you need to know about Social Security COLAs; you'll understand how Social Security raises are calculated, what will affect the raise you receive, and why your raise doesn't always mean you get more money. You'll find out:

• What COLAs are
• How the amount of a COLA is determined
• How much Social Security COLAs are actually worth
• Why there might not be a COLA every year
• How to learn the current year's COLA
• When the COLA becomes effective
• Whether COLAs actually ensure that Social Security benefits keep pace with increasing costs of living for seniors
• Why you may not get a larger Social Security check, even if there is a COLA

What are Social Security COLAs?

A COLA is a periodic increase in Social Security benefits. Social Security retirement benefits go up when there is a COLA. The increase is always calculated as a percentage of your current benefits. As a result, the higher your Social Security benefits, the higher your COLA.

For example, in 2019, there was a 2.8% COLA. If you were previously earning Social Security benefits of $1,500 per month, your COLA would be calculated by multiplying 2.8% times $1,500; it would equal $42 per month. Your new monthly benefit would be $1,542, and the COLA would result in an increase of $504 in total Social Security income in 2019. If your benefits were only $1,000 a month, you'd multiply $1,000 by 2.8%. Your COLA would result in a Social Security raise of $28 per month, so your new benefit would be $1,028 and you'd receive $336 more over the year.

How are Social Security COLAs calculated?

Social Security COLA adjustments are pegged to growth in the Consumer Price Index for Urban Wage Earners and Clerical Workers, or CPI-W. The CPI-W measures the average change in prices paid over time for consumer goods and services purchased by urban wage earners and clerical workers. Prices are tracked every month to determine how they're changing.

Eight major spending categories are tracked to determine changes in prices in order to calculate the CPI-W. These are:

• Foods and beverages (meats, snacks, dairy products, full-service meals)
• Housing (rent or equivalent costs for owners, heating and cooling, furniture)
• Clothing and apparel (shirts, pants, dresses, sweaters, jewelry)
• Transportation (airfare, new car costs, car insurance, gas)
• Healthcare (prescription drugs, medical supplies, doctor and hospital services)
• Recreation (pet products, TVs, toys, event admissions)
• Education and communication (phone services, computer services, shipping costs, school tuition)
• Other goods and services (such as personal services)

In looking at the CPI-W, the Social Security Administration uses a particular set of data -- that from the third calendar quarter, consisting of July, August, and September. The SSA takes the average of the CPI-W for these three months of the current year, and compares it to the highest third-quarter average CPI-W ever recorded. The past CPI-W that's compared to the current year is called the "computation quarter."

Usually, the "computation quarter" ends up being the third quarter from one year before. This makes sense, because prices tend to go up from year to year instead of going down. So, to calculate the COLA beneficiaries would receive in 2019, the SSA took the CPI-W for July, August, and September 2018 and compared this to the highest average CPI-W in any prior year.

You can find the CPI-W dating back to 1974 on the Social Security website. Let's look at an example using data from 2018 to see how COLAs are actually calculated:

• The CPI-W in July 2018 was 246.155.
• The CPI-W in August 2018 was 246.336.
• The CPI-W in September 2018 was 246.565.

The average of those three numbers is 246.352.

Since 2017 had the highest average CPI-W of any past year before 2018, we'd compare the 2018 average for these three key months to the 2017 average CPI-W for the same three months:

• The CPI-W in July 2017 was 238.617.
• The CPI-W in August 2017 was 239.448.
• The CPI-W in September 2017 was 240.939.

The three-month average for 2017 was 239.668. So, we need to figure out the percentage increase from 239.668 to 246.352. We do this using the following calculation:

• Take the current year's CPI-W, subtract the computation quarter's CPI-W, and divide this number by the computation quarter's CPI-W. Then multiply by 100%. This shows you the percentage increase in CPI-W from the computation quarter to the current year.
• In our above example, the equation (rounding the result to the nearest tenth of a percentage point) looks like this: ((246.352 - 239.668) / 239.668) x 100% = 2.8%.

And that's why the Social Security COLA in 2019 was 2.8%.

How much are Social Security COLAs?

Social Security COLAs vary depending on how much the CPI-W changes from year to year. The table below shows COLAs for every year dating back to 2010:

Data source: Social Security Administration.

You can find a full summary of COLAs dating all the way back to 1975 on the website of the Social Security Administration. As you can see, in some years, there's no increase in benefits; in other years, the Social Security COLA is quite small.

Why would there be no COLA?

According to the Social Security Act, there's an automatic COLA only if the average CPI-W in the third quarter of the current year is higher than the CPI-W in the computation quarter. But sometimes this doesn't happen. This can get confusing, so let's look at an example.

Here's what happened with the 2010 COLA. Remember, the 2010 COLA was calculated by comparing the 2009 CPI-W with the CPI-W from past years:

• In 2009, the average CPI-W for July, August, and September was lower than the average CPI-W in the third quarter of 2008 (which was the previous highest average CPI-W).
• Because of this, there was no automatic COLA.
• The third quarter of 2008 remained the computation quarter, since its average CPI-W was higher than the average third-quarter CPI-W in 2009.

And here's what happened with the 2011 COLA, which was calculated by comparing the 2010 CPI-W with the CPI-W from previous years:

• In 2010, the average third-quarter CPI-W from 2010 wasn't compared with 2009 -- it was compared with 2008. That's because the 2008 CPI-W average was higher than the 2009 average. The 2008 CPI-W from July, August, and September was still the highest CPI-W ever recorded in any past year, so it continued to be used as the computation quarter.
• The average CPI-W in the third quarter of 2010 was higher than the average CPI-W in 2009, but was NOT higher than the average in 2008.
• Since 2008 was still the computation quarter, there was no increase again.

That's why there was no COLA in 2011 either.

But in 2011, the average CPI-W in July, August, and September did exceed the average CPI-W in the 2008 computation quarter, so there was a COLA for 2012. The 2011 average CPI-W became the computation quarter, and was used to calculate the COLA in 2012, because it was higher than any past average CPI-Ws.

How can I find out what the annual Social Security COLA is?

You will receive a notice if there is a Social Security COLA. These notices are available online if you sign into your "my Social Security" account.

The Social Security Administration generally announces COLAs well before the notice is sent to beneficiaries in December. In fact, the SSA announced the 2019 COLA on Oct. 11, 2018. You can watch the news to see reports of COLA adjustments (The Motley Fool always has them), or you can visit the SSA website, which addresses COLAs periodically, to see if there are any updates.

When does the COLA become effective?

When there is a COLA, it becomes effective in December of the current year. The first increase in Social Security payments from the COLA begins in January of the following year. So the COLA for 2019 became effective in December 2018, and Social Security recipients saw their first increased payments when they received their January 2019 Social Security checks.

Are Social Security COLAs actually a good measure of the rising cost of living?

You probably noticed above that the price index used to calculate Social Security COLAs is called the Consumer Price Index for Urban Wage Earners and Clerical Workers. Perhaps that gave you pause -- after all, senior citizens who are collecting Social Security benefits are usually not urban wage earners, nor are they clerical workers.

In fact, the choice of the CPI-W to calculate Social Security COLAs has been called into question numerous times, because urban wage earners and clerical workers tend to spend their money on different things than senior citizens do. Seniors usually spend a larger share of their income on housing and healthcare compared with younger workers, for example. And they may spend less money on other expenditures, such as entertainment and transportation. Since the CPI-W gives more weight to spending categories where seniors don't spend heavily, and less weight to categories where they do spend heavily, using the CPI-W may not adequately measure the actual inflation that seniors experience.

There is actually another price index, called the Consumer Price Index for the Elderly (CPI-E), which many experts argue should be used to determine COLAs instead of the CPI-W. The CPI-E gives far more weight to housing and healthcare than the CPI-W does, as the chart below shows:

A switch to using the CPI-E instead of the CPI-W to calculate COLAs would result in Social Security recipients receiving slightly higher COLAs each year. These small additional sums of money would add up over time. For example, if COLAs were calculated based on the CPI-E instead of the CPI-W over a period of 30 years, a hypothetical beneficiary who earned the average national wage would receive at least $100 more in benefits each month.

This change may be justified, as seniors lose ground under the current COLA formula when healthcare and housing costs rise faster than Social Security benefits do. In fact, since 2000, benefits have lost a full 34% of buying power.

You'll notice the chart also lists a third Consumer Price Index: the CPI-U. CPI-U stands for Consumer Price Index for All Urban Consumers.

The Bureau of Labor Statistics also created an index called the Chained Consumer Price Index for All Urban Consumers (C-CPI-U). The chained CPI works differently than the other price indexes, because it assumes people will change their buying habits if some prices go up. For example, the Chained CPI assumes that if the price of beef goes up, people might buy more pork and less beef. Some have also argued that the Chained CPI should be used to calculate COLAs. This would result in a smaller increase in benefits, reducing the cost of the Social Security benefits program.

Why do COLAs not always result in increased Social Security benefits?

When Social Security announces a COLA, you might assume that seniors receiving Social Security checks will get a raise equal to that adjustment. Unfortunately, this isn't always the case. That's because you have to account for Medicare premiums.

Medicare Part B charges monthly premiums for senior citizens who receive health insurance coverage through the program. Premiums are generally deducted directly from Social Security checks before the check reaches the recipient. And these premiums go up over time. The premium that's set by Medicare each year is called the standard premium.

If the standard Medicare premium goes up, some of the COLA adjustment is used to pay the extra premium. Say, for example, you're set to receive a $30-per-month raise from Social Security thanks to a COLA -- but the standard Medicare premium has also risen by $29 per month. You'd get that raise, but $29 of it would immediately be taken out of your Social Security check to pay for the higher Medicare prices. The result: Your Social Security check would be only $1 higher, despite a COLA worth $30 per month.

If Medicare premiums rose more than the Social Security COLA, or if there were a premium increase but no COLA, seniors might theoretically see their Social Security checks go down in value. This doesn't actually happen, though, thanks to "hold harmless" provisions that make sure no senior gets a smaller Social Security check because of rising Medicare costs.

These provisions mean seniors may pay less than the standard Medicare premium -- for a while. If this is happening and a COLA occurs, though, seniors have to catch back up to paying the full premiums. This can result in a big jump up in Medicare costs that eats up the entire COLA adjustment.

In 2017, for example, the standard Medicare premium was set at $134. But there was a really small 0.3% COLA in 2017, so the hold harmless provision meant most seniors had only $109 in Medicare premiums deducted from their Social Security checks. All these seniors were paying $25 less than the actual cost of Medicare premiums.

The standard Medicare premium remained at $134 in 2018 -- but that year, seniors got a COLA that amounted to an increase in benefits averaging about $27 per month. The problem: Seniors now had to pay that extra $25 in Medicare premiums that the hold harmless provisions had protected them from in the previous year. So, the $25 premium increase took nearly all of the $27 average raise, and about 70% of retirees saw no extra money in their Social Security checks in 2018, even with a 2% COLA.

So, long story short: If Medicare premiums go up as much as or more than your COLA, you'll theoretically get a raise -- but won't see any extra cash, because the additional money is taken right out of your check to pay for Medicare.

Now you understand everything there is to know about Social Security COLAs

Now you know that Social Security COLAs are periodic increases in Social Security benefits. COLAs typically result in a percentage increase in your Social Security benefits; however, if Medicare premiums go up more than your COLA, you won't see any extra money in your Social Security check.

COLAs are calculated based on changes in a pricing index called the CPI-W, which measures changes in prices in eight key spending categories including food, housing, transportation, and entertainment. The CPI-W may not be the best pricing index to calculate COLAs, because it measures changes in the prices of goods and services used by urban wage earners and clerical workers. Some argue COLAs should instead be pegged to the CPI-E, which is a better measure of pricing changes affecting elderly people. The use of the CPI-W instead of the CPI-E has resulted in smaller benefits increases over time, and Social Security benefits have lost buying power as a result.

Because COLAs are percentage increases in your benefits, if you receive larger Social Security benefits, your COLAs will be worth more. This is one reason it's a good idea to try to increase the Social Security benefits you receive. You can increase your benefits by working longer to earn delayed retirement credits, or by aiming to maximize your income over your working life.

You can also advocate for the SSA to switch to the CPI-E, which would likely result in higher Social Security COLAs each year.