Whether you realize it or not, Social Security plays a big role in helping to secure the financial well-being of our nation's retired workforce. When non-retirees were asked by Gallup to what extent they plan to lean on their Social Security income during retirement, only 15% in 2021 responded that it wouldn't be necessary. Of the remaining respondents, 38% said it would be a “major” source of income, which represents an all-time high for this particular poll (dating back to 2001).
Given the importance of Social Security income for current and future retirees, there's arguably no announcement more awaited than the annual cost-of-living adjustment, or COLA, which is released during the second week of October.
What is Social Security's COLA, and how is it calculated?
In simple terms, COLA is the “raise” that the more than 65 million Social Security beneficiaries can expect to receive from one year to the next to account for inflation (i.e., the rising price of goods and services).
Social Security's COLA is determined by changes in the Consumer Price Index for Urban Wage Earners and Clerical Workers, or CPI-W (thank goodness for acronyms). The CPI-W has eight major spending categories and dozens upon dozens of subcategories, each of which has their own respective weighting. As the price for this predetermined basket of goods and services changes, the CPI-W can cull this data into an easy-to-understand figure.
However, only a narrow time frame is taken into account when calculating Social Security's COLA. Only the CPI-W readings from the third quarter (July through September) are used to determine the following year's “raise.” While the other nine months can be helpful in identifying trends, they have zero bearing on the final COLA reading.
Thus, to keep things simple, the Social Security COLA is simply the average CPI-W reading in the third quarter of the current year compared to the average CPI-W reading in the third quarter of the previous year. If the average CPI-W reading rises in the current year, beneficiaries will receive a higher payout in the following year that's commensurate with the percentage increase in the average third-quarter CPI-W reading, rounded to the nearest tenth of a percent.
More than half the country could witness a Social Security first
But for more than half the country (approximately 169 million Americans, per U.S. Census Bureau estimates), the upcoming year could mark a historic event.
On Aug. 11, the U.S. Bureau of Labor Statistics released inflation data for July 2021. This report showed that the CPI-W increased by 6% over the trailing 12 months. Keep in mind this represents just one of the three monthly readings needed to calculate Social Security's COLA. However, it signifies that the 2022 COLA could be the highest we've seen in a long, long time.
According to The Senior Citizens League (TSCL), a nonpartisan senior advocacy group, Social Security's COLA is estimated to rise by 6.2% in the upcoming year. This would mark the biggest jump in benefit payouts since the 7.4% COLA announced in 1982 and passed along in 1983. In other words, the last time Social Security passed along a benefit hike this large, roughly 169 million Americans alive today weren't even born.
If you're looking for a good reason or two why prices are rising so quickly, energy and transportation can take a lot of the blame. In July, the Consumer Price Index for All Urban Consumers (CPI-U), a similar measure to the CPI-W, showed an unadjusted 23.8% increase in energy costs over the trailing 12 months. This is a direct result of crude oil and natural gas prices rising considerably as U.S. economic activity has rebounded from its recession low.
Likewise, vehicle and transportation costs are going through the roof. Prices of used cars and trucks showed a 41.7% increase in July (for the CPI-U) from the prior-year period, with transportation service expenses up 6.4%.
A historically large payout bump for beneficiaries isn't a reason to cheer
On the surface, the 65 million existing Social Security beneficiaries would likely be thrilled with a 6.2% benefit hike. After all, COLA increases have only averaged about 1.4% over the past 12 years, and that includes three years where no COLA was passed along at all. A 6.2% increase would lift the average retired worker's monthly benefit by about $97, or more than $1,160 a year.
However, two important things need to be understood here. First, the COLA isn't designed to help retired workers “get ahead.” It's merely a device designed to keep pace with the prevailing rate of inflation. Therefore, most of Social Security's 65 million beneficiaries can expect their pay raise to be offset by the rising price of goods and services throughout various facets of the economy.
Second, the purchasing power of Social Security dollars has been declining precipitously since the beginning of the century. According to a report issued by TSCL in May, beneficiaries have lost 30% of their buying power since 2000. To put this another way, what $100 in Social Security income could buy in 2000 will now only purchase about $70 worth of those same goods and services. Payout increases simply haven't kept up with the real inflation seniors are contending with.
If you're wondering why there's been such a huge disparity between Social Security's COLA and the actual inflation rate seniors are dealing with, look no further than the CPI-W. As its official name implies, the CPI-W tracks the spending habits of urban and clerical workers who, in many cases, are working-age people who spend very differently than seniors. As a result, important expenses for seniors, such as medical care and shelter, are relatively underweighted in the CPI-W, while less-important costs, such as education and apparel, are given increased weighting. This disparity is what's led to Social Security beneficiaries losing some of their purchasing power.
While 2022's COLA could be the highest in nearly four decades, it's not a cause for celebration.
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