How COLAs Are Calculated -- and Why the Formula May Not Reflect What You Actually Pay
Key Points
The Social Security COLA formula is based on workers' spending habits, not retirees'.
There is a separate inflation index that tracks senior spending habits, the CPI-E.
A switch to the CPI-E would increase COLAs in most years, but that's unlikely to happen in the near future.
- The $23,760 Social Security bonus most retirees completely overlook ›
If you've been on Social Security for a few years, you've probably settled into a familiar pattern: You eagerly anticipate the next year's cost-of-living adjustment (COLA), but when the benefit boost arrives, you don't feel like you're actually getting ahead, or even keeping up with where you were. So you set your sights on the next year's COLA, hoping that one will be better.
You're not alone in doing this, and you're not imagining things, either. There's a real reason your COLAs don't seem like they're keeping pace with your expenses, and it has to do with how the Social Security Administration calculates them in the first place.
Where to invest $1,000 right now? Our analyst team just revealed what they believe are the 10 best stocks to buy right now, when you join Stock Advisor. See the stocks »
Image source: Getty Images.
COLAs aren't based on senior spending habits
If someone tasked you with deciding how future Social Security COLAs should be calculated, you might look at how much the average senior's spending has increased from one year to the next and make that amount the COLA. That's not what the government did.
When it created the COLA formula we use today, it based COLAs on average third-quarter inflation rates as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). This index only includes households where at least one member has been employed for at least 37 weeks during the previous year, and where at least 50% of household income comes from wage earnings. That rules out most retiree households by default.
Since the CPI-W focuses on the spending habits of workers, many of whom are younger and healthier than retirees, it can cause COLAs to underweight some key expense categories for seniors, such as healthcare, which often rises faster than the standard inflation rate. The result is a COLA that increases benefits without increasing buying power.
The ironic thing is that there is an index for specifically tracking senior spending habits: the Consumer Price Index for the Elderly (CPI-E). Many seniors and some members of Congress have called for the government to switch to the CPI-E for COLA calculations. This would increase COLAs in most years.
Why don't we base COLAs on the CPI-E?
Changing to the CPI-E would require Congress to update the Social Security COLA formula. That's difficult because of partisan politics, but also because higher COLAs would increase the program's expenses. This could cause the trust funds, which are already expected to be depleted in 2032, to run out even sooner. That could force a 22% benefit cut unless the government intervenes.
It doesn't mean we'll never see a change to the CPI-E, but I wouldn't expect it to happen for a little while. We'll likely have to wait until Washington decides on a plan to keep Social Security sustainable before changes to the COLA formula occur.
The $23,760 Social Security bonus 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 ensure a boost in your retirement income.
One easy trick could pay you as much as $23,760 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Join Stock Advisor to learn more about these strategies.
View the "Social Security secrets" »
The Motley Fool has a disclosure policy.
