Understanding COLA: How Social Security Benefits Keep Pace with Inflation

Caption: COLA is the link that ties inflation with social security benefits

It can be called a ‘bitter-sweet’ moment. While the inflation rate is falling, it could lower the cost-of-living adjustment (COLA) in 2024. According to the latest report by the Senior Citizens League, a nonpartisan seniors advocacy group, COLA can drop to as low as 2% Source

If you are planning to rely on Social Security benefits in your retirement , it is essential to understand the link between social security benefits and inflation.

The answer lies in a critical mechanism called COLA.

Due to the increasing cost of living or inflation, retirees may find their social security benefits diminish over time, making it harder to cover their living expenses.

Here’s where COLA comes into the picture. It is an annual adjustment to Social Security benefits that take into account the changes in the cost of living as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). It ensures that the purchasing power of Social Security benefits remains relatively stable over time.

While next year’s rate is low, this isn’t the case every year. In fact, Social Security fixed 2023’s rate to 8.7%. It happened to be the largest inflation adjustment to benefits in four decades. Nearly 70 million beneficiaries welcomed this development.

In this blog, we will explore the intricate workings of COLA and shed light on how it ensures that Social Security benefits keep pace with inflation. We’ll break down the significance of COLA, discuss the factors that influence its calculation, and how you can prepare better for retirement.

History & rationale for implementing COLA

It all started in the early 1970s when the cost of living rose, and retirees were finding it increasingly challenging to make ends meet with their fixed Social Security benefits.

Social Security benefits remained static, meaning they didn’t automatically increase with inflation back then. So, the retirees found everyday items, such as groceries, rent, and medical needs expensive compared to their income. It created a financial burden for many retirees struggling to keep up with the rising costs.

Caption: COLA ensures that purchasing power of Social Security benefits remains relatively stable over time

COLA was introduced to address this issue in 1975. The idea was simple but impactful: to match Social Security benefits with the changing cost of living. COLA was rooted in fairness, recognizing the real-life impact of inflation on retirees.

Before 1975, the benefits changed when approved special legislation. The first COLA was determined by the change in the Consumer Price Index CPI-W between the second quarter of 1974 and the first quarter of 1975.

From 1976 to 1983, the COLAs were determined by the changes in the CPI-W between the first quarter of the previous year and the corresponding quarter of the current year. However, since 1983, COLAs have been based on the increase in the CPI-W from the third quarter of the previous year to the corresponding quarter of the current year in which the COLA became effective.

America experienced its highest COLA rate, 14.3%, in 1980. The inflation rate was 13.5%. COLA did not see such a dramatic increase in the 90s, 2000s and 2010s due to lower inflation rates till 2023.

How Is COLA Calculated?

The calculation of COLA (Cost of Living Adjustment) is based on the changes in the CPI-W. Here’s a simplified explanation of how COLA is calculated:

The calculation begins by selecting the reference period, which is the timeline used to compare the cost of living from the previous year. The values are compared between the reference periods. ​​To calculate the percentage increase, the Social Security Administration subtracts the average CPI-W from the previous year’s third quarter from the average CPI-W of the current year’s third quarter.

Once the percentage increase is determined, it is applied to Social Security benefits. This percentage increase is added to the current benefit amount and adjusted to reflect the change in the cost of living.

Criticisms and debates surrounding COLA and alternative proposals

One common criticism is the accuracy of the CPI-W, which serves as the basis for COLA calculations. Some argue CPI-W is not fully capturing the cost-of-living changes experienced by retirees and beneficiaries.

They suggest using alternative indices, such as the Consumer Price Index for the Elderly (CPI-E), which tracks the spending patterns of older adults.

President Joe Biden’s latest 4-point plan to boost Social Security supports this. He proposes shifting from the CPI-W to CPI-E to accurately determine inflation’s impact on retirees and beneficiaries. Source

Critics argue that COLA adjustments are based on historical data, meaning that beneficiaries experience a delay before seeing the impact of inflation on their benefits. This lag can result in a gradual decline in purchasing power over time. Some propose implementing adjustments more frequently or using a different methodology.

Take the instance of 2022. Although the COLA rate was 5.9% (which at the time was the highest in four decades), it was immediately met by a higher inflation rate of 7%. Source.

A similar gap is between 2000 and 2022. According to The Senior Citizens League report, although COLAs increased benefits by 64% in 22 years, the cost of goods and services rose 130%.

Caption: COLAs benefits rose by 64% but the cost of goods rose 130% between 2000-2022

Another criticism revolves around how COLA affects income inequality. Critics say applying the same COLA percentage to all Social Security benefits, regardless of income level, can increase inequalities.

For low-income groups, a lower COLA means a loss of purchasing power. Some propose implementing a progressive COLA, where higher-income individuals receive a lower adjustment percentage, while lower-income individuals receive a higher adjustment percentage.

The Chained Consumer Price Index (CPI) is another alternative proposal that has generated debate. It takes into account the substitution effect. Under this, as prices change, consumers change what they buy. It is based on the assumption that consumers will adjust their spending habits in response to price changes. Source.

Caption: COLA can be calculated using Chained Consumer Price Index (CPI) according to some critics

Supporters argue that the Chained CPI provides a more accurate reflection of consumer behavior. Meanwhile, critics say it may result in lower COLA adjustments over time and reduce benefits for retirees and beneficiaries.

Another proposal suggests a more targeted approach. It means providing supplements based on healthcare costs, housing expenses, or geographical location.

It is important to note that the debates surrounding COLA and alternative proposals aim to maintain a balance in the purchasing power of benefits and address the evolving needs of retirees and beneficiaries. Finding the most suitable approach requires careful consideration of the impacts on various groups.

How You Can Better Prepare For Retirement

The older generations were bang on when they preached about early savings. From your very first job, inculcate a savings habit. Take advantage of retirement savings options like employer-sponsored 401(k) plans, individual retirement accounts (IRAs), or Roth IRAs. The earlier you start, the more time your savings have to grow through compounding interest.

You can also take advantage of any employer-matching contributions to your 401(k) or similar plans. It can help significantly boost your savings over time.

You can do so by preparing a budget that prioritizes saving for retirement. Track your income and expenses and allocate a portion of your earnings towards retirement each month. Focus on cutting unnecessary expenses.

Once you have budgeted for savings and expenses, start investing. Invest your money across a mix of asset classes to spread the risk and potentially increase your returns. Consider consulting a financial advisor to help you develop an investment strategy that aligns with your goals, risk tolerance, and time horizon.

Start saving early and invest to better prepare for your retirement  Allocate a small chunk of your earnings to build an emergency fund to cover unexpected expenses and emergencies. This fund will prevent you from dipping into your retirement savings.

While doing the above, it is essential to gain financial literacy. Learn how different investment options, tax implications, and long-term financial planning strategies work. The more knowledge you have, the better equipped you’ll be to make informed decisions about your retirement savings. Keep yourself updated on changes in retirement policies, Social Security, and other relevant regulations.

Consider the potential for a longer life expectancy when planning for retirement. Account for healthcare costs, long-term care, and other expenses that may arise during your retirement.

Remember, retirement planning is a long-term process, and your strategy may evolve as you progress through different life stages. Regularly reassess your goals, adjust your savings contributions as your income increases, and seek professional advice when needed. By starting early and being proactive, you’re taking steps towards securing a comfortable retirement in the future.

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