If you’re receiving Social Security benefits (or expect to someday), you’ve probably heard some people discuss the program’s cost-of-living adjustments, or COLAs, with the same excitement as the first moon landing.
But that’s also understandable.
Social Security plays a big role in many people’s retirement finances. So a larger COLA versus a smaller one could spell the difference between being able to cover retirement expenses and struggling. If you’re wondering where Social Security’s COLAs come from and how they’re calculated, these are good questions to be asking. Getting the back story on COLAs could help you understand what to expect from benefit increases and why you probably need a backup plan for fighting inflation.
Read: Analyst drastically lowers Social Security COLA estimate
The purpose of Social Security COLAs
The idea behind Social Security COLAs is pretty simple. Over time, prices tend to rise due to inflation. If Social Security benefits stayed frozen year after year, retirees would gradually lose purchasing power. COLAs are designed to prevent that from happening by raising benefits in line with inflation. To put it another way, the goal of COLAs isn’t to make you richer. It’s to simply ensure that Social Security checks don’t lose buying power from year to year.
Congress doesn’t randomly choose a number
You might assume that it’s up to lawmakers to determine what Social Security COLAs look like. But there’s a much simpler, automated system at play.
The Social Security Administration (SSA) uses inflation data collected by the federal government to calculate COLAs. Specifically, it looks at a measure called the Consumer Price Index for Urban Wage Earners and Clerical Workers, or CPI-W (yup, it’s a mouthful). The CPI-W tracks price changes across a wide range of goods and services that consumers purchase, including food, transportation, housing, and other common expenses. Each year, officials compare the average CPI-W reading from the third quarter to the average from the same period a year prior. If there’s an increase, Social Security benefits get a boost.
What if there’s no increase? In that case, Social Security benefits remain flat. And the same holds true even if there’s a decrease in the CPI-W from one year to another.
Social Security benefits are not allowed to decrease from one year to the next. In fact, there’s a special “hold harmless” provision which ensures that recipients won’t see their monthly benefits whittled down when there’s no COLA plus an increase in the cost of Medicare Part B, whose premiums are deducted from Social Security benefits for dual enrollees.
Larger COLAs aren’t always good news
Social Security COLAs can vary substantially. During periods when prices remain relatively stable, COLAs tend to be smaller. When inflation accelerates, benefit increases often become larger as well. But one thing to remember is that larger Social Security COLA raises aren’t necessarily something to celebrate. A larger boost might seem great at first, but it comes at the cost of higher prices.
On the flipside, smaller COLAs shouldn’t be regarded as a bad thing. If your Social Security checks barely go up one year, it means your costs have probably remained mostly stable, too.
Why some advocates say Social Security COLAs aren’t enough
Even though the current Social Security COLA formula has been in place for decades, some advocates are pushing for a change on the basis that the CPI-W does not accurately reflect the costs seniors face. And that’s valid. After all, urban wage earners and clerical workers are apt to spend their money differently than retirees. While workers may throw more money at transportation, Social Security recipients might have higher healthcare bills.
The latter is important, because healthcare costs tend to outpace broad inflation. So if Social Security COLAs are being calculated using an index that doesn’t account for that, it’s easy to see how retirees could lose out.
What COLAs mean for your retirement planning
Any good retirement plan should include strategies to keep up with and beat inflation. Social Security’s COLAs can be part of yours, but they should not be viewed as a complete inflation shield. Instead, it pays to load up on investments that can beat inflation over time. That could mean keeping a portion of your retirement portfolio in growth and dividend stocks.
The bottom line on Social Security COLAs
Social Security COLAs exist to ensure that benefits don’t automatically lose buying power from year to year due to inflation. But they’re not meant to help retirees get ahead financially.
It’s important to understand how COLAs are calculated and exactly what they’re meant to do so you can come up with your own plan to conquer inflation. And part of that plan could involve adjusting your spending strategically during periods when consumer prices are running rampant.
One final thing you should know about Social Security COLAs? You’ll typically see monthly projections on them all year long. But since those COLAs are based on third quarter inflation readings, the SSA doesn’t make them official until October. Any estimate you see before that is really just a guess.
So if you’re on Social Security or are about to sign up, you may not want to sink too much time into tracking COLA estimates month after month. And if you have plenty of savings and outside income streams, you really shouldn’t have to.