For the vast majority of working Americans, Social Security will play a vital role in their financial well-being in retirement. According to a recent poll by national pollster Gallup, 84% of non-retirees expect to rely on Social Security as their “major” or “minor” source of income in their golden years. This aligns fairly consistently with the 89% of already retired seniors who rely to some degree on Social Security income to make ends meet each month.
Given the importance that Social Security income plays, or will play, for most Americans, there is arguably no more anticipated announcement each year than the Cost of Living Adjustment (COLA). of October.
What is the Social Security cost of living adjustment and how is it calculated?
Without getting too technical, think of Social Security’s COLA as the “increase” that is passed on to the program’s more than 65 million recipients most years. You’ll notice I put “increase” in quotation marks to indicate that this annual increase in payouts is intended to account for inflation that program recipients have faced and is not designed to help recipients ” go forward”. Simply put, if the price of goods and services rises, social security benefits should, ideally, rise in tandem.
Since 1975, the inflationary anchor of social security has been the consumer price index for urban wage and office workers (CPI-W). The CPI-W has eight major expense categories and dozens of subcategories, all of which have their own respective percentage weightings. These weights allow us to measure the price changes of a wide basket of goods and services, while reporting them as a single, tidy number that indicates whether inflation (rising prices) or deflation (lower prices) occurs.
Interestingly, the Social Security COLA is determined using only the CPI-W readings from the third quarter of the current year (July through September) and the third quarter of the previous year. Although the other nine months of the year can be useful in identifying trends, they will not be taken into account in the calculation of the Social Security cost of living adjustment.
If the average CPI-W reading for the third quarter of the current year is higher than the average CPI-W reading for the third quarter of the previous year, inflation has occurred and beneficiaries program will see their benefits increase in January. The amount of the increase is based on the year-over-year percentage increase in the average CPI-W reading in the third quarter, rounded to the nearest tenth of a percent.
Social Security’s 2023 COLA could be huge (but it’s far from a record high)
In the coming year, Social Security recipients should see their monthly checks soar. According to Mary Johnson, a Social Security policy analyst at the Senior Citizens League (TSCL), a nonpartisan seniors advocacy group, the program’s COLA could reach 11.4% in 2023 if inflation continues to rise in the third trimester.
By December 2022, I estimate the average retired worker will take home $1,683 per month. A COLA of 11.4% would therefore translate into a monthly increase in benefits of almost $192 in January. In short, the average retired worker could earn up to $1,875 per month in January 2023.
To put this in some context, there have only been two double-digit annual COLAs since the CPI-W became the program’s inflationary link in 1975. In 1981 and 1982, recipients received increases 14.3% and 11.2% respectively. This means that Johnson’s peak forecast of a COLA of 11.4% would, if accurate, be the second highest COLA in what I would call the “modern era” of Social Security.
But encompassing all of Social Security history, a COLA of 11.4% wouldn’t be close to a record high. This is because prior to 1975, cost-of-living adjustments were arbitrarily distributed by special legislative sessions of Congress. Between January 1, 1940, when the first monthly benefits began, and 1975, lawmakers voted to increase monthly Social Security payments just 11 times. However, the vast majority of these increases involved double-digit increases in payout percentages.
The largest COLA for program recipients occurred in September 1950. After recipients had gone the entire 1940s without an inflationary increase, the 1950 Social Security Amendments introduced an adjustment (drum roll) of 77% of cost of living to monthly installments. Suffice it to say, nothing less than hyperinflation will ever dethrone this historic and entirely arbitrary COLA.
A historically high COLA is no cause for celebration
In one respect, the prospect of a historically high COLA is probably somewhat exciting for the tens of millions of Social Security recipients. On a nominal dollar basis, benefit increases in 2023 are expected to be higher than any year on record.
Unfortunately, all is not what it seems.
For example, if Social Security recipients are preparing to receive a historically high increase in their monthly payment, that also means they are facing historically high inflation. This suggests that a significant portion of the increase in Social Security checks in 2023 will be swallowed up by rising prices for housing, food, transportation and medical care.
Additionally, the inflationary link in Social Security has done poorly to account for the inflation that older people face. According to a TSCL report in May 2022, the purchasing power of Social Security income has declined by an almost unfathomable 40% since 2000. This means that what $100 of Social Security income bought in 2000 can no longer buy than $60 of those same goods and services.
The problem with the CPI-W, as its official name suggests, is that it focuses on the spending habits of urban wage earners and office workers. They are usually working-age Americans who do not receive Social Security benefits. More importantly, they spend their money very differently from seniors. Therefore, basic expenses for seniors, such as medical care and housing, are underweighted in the CPI-W. Meanwhile, smaller expenses, such as education, clothing, and entertainment, have higher weights.
Even though lawmakers are well aware of this problem and agree that the CPI-W does not particularly well measure the inflation that Social Security seniors face, neither major party has been willing to give an inch and to find common ground. with their opponent. In other words, Social Security recipients appear doomed to lose additional purchasing power over time, no matter how strong the COLA is for 2023 and beyond.
The $18,984 Social Security premium that most retirees completely overlook
If you’re like most Americans, you’re a few years (or more) behind on your retirement savings. But a handful of little-known “Social Security secrets” could help boost your retirement income. For example: an easy trick could earn you up to $18,984 more…every year! Once you learn how to maximize your Social Security benefits, we believe you can retire confidently with the peace of mind we all seek. Just click here to find out how to learn more about these strategies.
The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.