Social Security COLA: What's Working, What's Not

For example, the most common measure of price inflation is the CPI-U, Consumer Price Index for All Urban Consumers. Social Security uses the CPI-W (Consumer Price Index for Urban Wage Earners and Clerical Workers).

A criticism of using a basket of goods and services is that consumers will substitute other goods or services when prices rise. If beef prices rise, retirees will eat more chicken. 

The CPI-W takes this substitution effect into account, but some argue that it only accounts for low-level substitutions of close substitutes rather than high-level substitutions (such as buying more eggs for protein). 

The Chained CPI-U (Chained Consumer Price Index for All Urban Consumers) employs a formula that reflects the effect of substitution that consumers make across item categories in response to changes in relative prices.  

In 2012, the Chained CPI made national headlines as a possible solution for reducing the growth in Social Security benefits. Conservative groups (opposed by senior organizations such as the AARP) promoted the Chained CPI as a relatively painless way to cut over $100 billion from Social Security income over the following decade. 

The impact on income payments is relatively modest, resulting in growing benefits just a little bit less — an estimated 4% less by 2050.

CPI-W vs. CPI-E

Opponents of the use of more modest CPI measures point out that inflation may be underestimated by an index that doesn't reflect the budget of a retiree. Some have proposed switching to a COLA index more appropriate for seniors, such as the CPI-E (for the elderly). 

Unfortunately, the CPI-E is experimental and the Bureau of Labor Statistics warns that the CPI-E has significant methodological limitations that affect its ability to accurately capture changes in prices paid by retirees. Regardless of these limitations, the CPI-E actually closely tracks the other common measures of price inflation such as the CPI-W and Chained CPI.

Congress has introduced legislation that would tie future adjustments to the CPI-E. 

The Social Security Administration's Office of the Chief Actuary estimated in 2010 that basing future adjustments on the CPI-E would provide average annual COLAs that were about 0.2 percentage points higher than adjustments based on the current CPI-W. For 2020, had the CPI-E been used for COLAs, the increase would have been 1.9% instead of 1.6%, or 0.3 percentage points higher.

However, even though the CPI-E closely tracks the CPI-W, in some years, it was less than the CPI-W. For example, recalling the large COLA in 2009 and subsequent zero-COLAs in 2010 and 2011, if cost-of-living adjustments had been based on the CPI-E, there would actually have been a smaller increase in 2008 and there still would not have been an increase in 2009 or 2010. 

About 64 million Americans rely on Social Security benefits for income protection, including more than 48 million retired workers and their dependents. 

Among households headed by someone aged 65 or older, more than half rely on Social Security benefits for a majority of total income, while 19% depend on Social Security for at least 90% of income. The automatic cost-of-living adjustment to Social Security benefits helps ensure that retirees are protected against inflation risk. 

Planning for Future Retirement Expenses

One of the most difficult aspects of planning for expenses in retirement is estimating the cost of health care over an uncertain lifespan. 

Over the past two decades, the Medical Care Services category of the CPI experienced one of the highest increases in price inflation. 

As retirees live longer, financial advisors will need to help people plan for the high costs of assisted living facilities. The median cost of assisted living care was $51,600 a year in 2020, while the median cost for a private room in a nursing home was $105,850, according to the Genworth Cost of Care Survey. 

While the Social Security COLA is based on the CPI-W, which itself is based on eight major categories of spending, it is not a perfect measure of everyone's cost of living.

Budget shares for housing, energy and food may be higher for retirees in certain regions, while the cost of health care rises with age. Younger and wealthier retirees may spend more on leisure and travel.

Financial advisors need to recognize that changes in Social Security likely will not match changes in their clients' expenses, making the inflation protection an imperfect hedge against price volatility. 

Social Security COLAs are designed to increase purchasing power enough to keep Americans out of poverty. Managing inflation for a wealthy retiree requires different strategies that may involve the use of insurance to protect against health cost risks and investments that historically outpace price increases. 

The Future of Social Security COLAs

Numerous legislative proposals have been introduced over the years to change the way the Social Security COLA is calculated. Some proposals have suggested adopting the previously mentioned CPI-E, while others have suggested moving to a Chained CPI, which would account for changes in the goods and services consumers buy each year.

Regardless, there are no serious proposals to eliminate the Social Security COLA. Current and future retirees should continue to expect that Social Security benefits will be adjusted for some measure of increase in prices. 

However, the Social Security and Medicare programs themselves face financial problems, which could lead to future changes in benefits and possibly in the use of a more modest COLA index.

According to the Social Security Trustees, the combined OASI and DI trust funds face a financial shortfall of $16.8 trillion in present value through 2094 and $53.0 trillion over an infinite horizon.

Further, the Social Security trust funds will be depleted and unable to finance full benefits in 2035.

Unless Congress takes action to reform Social Security, the program will only be able to pay approximately 75% of estimated benefits when the OASI trust fund runs out of assets in 2035.

The Medicare program also faces a funding shortfall, with the most recent estimates suggesting that the hospital insurance trust fund could be depleted in 2026.

Financial advisors will need to help clients navigate the uncertainty and risk associated with the impact that the impending depletion of the Social Security trust funds will have on Social Security retirement benefits, Medicare premiums and retirement security.

— Related on ThinkAdvisor:

• Test Your Knowledge: The Social Security Trust Funds
• How Medicare Premium Hikes, Small Social Security COLAs Squeeze Retirees
• Why Social Security COLA Calculations Matter

Jason Fichtner is the associate director of the Master of International Economics and Finance Program at the Johns Hopkins School of Advanced International Studies. Michael Finke, Ph.D., CFP, is a professor of wealth management and Frank M. Engle Distinguished Chair in Economic Security at The American College of Financial Services.