Social Security Explained – Part 1 of 5

How Your Social Security Cost-of-Living Adjustment (COLA) Is Calculated—and Why It May Not Keep Pace With Your Expenses

One of the most valuable features of Social Security is that it provides an annual Cost-of-Living Adjustment, commonly known as a COLA. Unlike many private pensions, Social Security benefits are designed to increase over time in an effort to help retirees keep up with inflation.

For millions of Americans, the annual COLA can make a meaningful difference in maintaining purchasing power throughout retirement. Yet many people don’t understand how the adjustment is calculated, why some years produce much larger increases than others, or why many retirees feel their personal expenses are rising faster than their Social Security benefits.

In this first installment of our five-part Social Security series, we’ll explore the history of the COLA, how it’s calculated, the inflation measure used by the Social Security Administration, and why economists continue to debate whether a different method would better reflect retirees’ actual living expenses.

A Brief History of Social Security COLAs

When Social Security was signed into law by President Franklin D. Roosevelt in 1935 as part of the New Deal, there was no automatic inflation adjustment.

Instead, any increase in benefits required Congress to pass new legislation.

Between 1950 and 1972, Congress approved several benefit increases, but they occurred only after lawmakers acted. During periods of high inflation, retirees often saw their purchasing power erode while waiting for Congress to respond.

Recognizing this problem, Congress passed the Social Security Amendments of 1972, creating the automatic Cost-of-Living Adjustment beginning in 1975.

Since then, benefits have increased automatically whenever inflation, as measured by the government’s formula, warrants an adjustment.

A Look Back at COLA History

Annual COLAs have varied dramatically over the years.

During the high inflation of the late 1970s and early 1980s, retirees received double-digit increases.

Examples include:

·         1980: 14.3%

·         1981: 11.2%

More recently:

·         2009: 5.8%

·         2010: 0.0%

·         2011: 0.0%

·         2022: 5.9%

·         2023: 8.7% (the largest increase in over four decades)

·         2024: 3.2%

·         2025: 2.5%

·         2026: 2.7%

These annual adjustments are not “raises.” Instead, they are intended to help preserve purchasing power as prices increase over time.

How Is the COLA Calculated?

The Social Security Administration bases each year’s COLA on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), published monthly by the Bureau of Labor Statistics.

Rather than using inflation for the entire year, Social Security compares:

·         The average CPI-W for July, August, and September (the third quarter) of the current year

·         With the average CPI-W for the third quarter of the previous year in which a COLA was determined.

If the index increases, Social Security benefits increase the following January.

If prices do not increase, there is no COLA, as happened in both 2010 and 2011.

What Is Included in CPI-W?

The CPI-W measures changes in prices paid by households whose primary income comes from wage earners and clerical workers.

The index includes spending on:

·         Housing

·         Food and beverages

·         Transportation

·         Medical care

·         Recreation

·         Education

·         Apparel

·         Communication

·         Other consumer goods and services

Each category receives a weighting based on how much the average working household spends in those areas.

Why Some Economists Criticize the CPI-W

Although the CPI-W has been used for Social Security since automatic COLAs began, many economists question whether it accurately reflects the inflation experienced by retirees.

The reason is simple.

Retirees spend money differently than younger working families.

Compared to workers, retirees typically spend:

·         More on healthcare

·         More on prescription medications

·         More on housing

·         More on utilities

·         Less on commuting

·         Less on gasoline

·         Less on work-related expenses

·         Less on education

Healthcare costs have historically increased faster than overall inflation, leading many retirees to feel that their personal inflation rate is higher than the annual COLA they receive.

Alternative Inflation Measures

Over the years, several alternatives have been proposed.

CPI-E

The Consumer Price Index for the Elderly (CPI-E) tracks spending patterns for households headed by individuals age 62 and older.

Because older Americans devote a larger portion of their budgets to healthcare, the CPI-E has historically produced slightly higher inflation readings than the CPI-W.

Supporters believe it better reflects the expenses retirees actually face.

Critics point out that the CPI-E remains an experimental index and would increase Social Security’s long-term costs.

Chained CPI

Another proposal is the Chained Consumer Price Index (C-CPI-U).

Unlike the CPI-W, the Chained CPI assumes consumers substitute less expensive products when prices rise.

For example, if beef becomes significantly more expensive, consumers may buy more chicken instead.

Because it assumes these substitutions occur, the Chained CPI generally grows more slowly than the CPI-W.

Supporters argue this provides a more accurate measure of inflation.

Opponents argue it would gradually reduce Social Security benefits over time.

Congress has considered both alternatives but has not adopted either one.

What About the 2027 COLA?

The official 2027 COLA will not be announced until October 2026, after inflation data for July, August, and September become available.

Current estimates suggest retirees may receive a COLA in the neighborhood of 2.5% to 2.7%, although that estimate could change depending on inflation during the summer months.

Common Misconception

Many people believe Congress votes each year on Social Security’s annual increase.

In reality, Congress created an automatic formula beginning in 1975. Unless lawmakers change the law itself, the annual COLA is determined by inflation—not by a yearly vote of Congress.

Planning Tip

While annual COLAs help preserve purchasing power, retirees should not assume their actual expenses will rise by the same percentage. Healthcare costs, long-term care expenses, homeowners insurance, and property taxes have often increased faster than Social Security benefits over long periods. Building flexibility into your retirement income plan can help offset these higher costs.

CFP® Perspective

One of the most common comments I hear from retirees is, “My Social Security went up, but everything I buy seems to have gone up even more.”

That observation isn’t necessarily wrong.

The annual COLA is based on the spending habits of working households—not retirees. Two individuals can experience very different inflation rates depending on how they spend their money. Someone with significant medical expenses may feel inflation much more acutely than someone whose largest expenses are relatively stable.

This is one reason comprehensive retirement planning goes beyond simply estimating investment returns. A retirement income plan should account for inflation, healthcare costs, taxes, and changing spending needs over a retirement that may last 25 to 30 years or longer.

Key Takeaways

·         Social Security did not receive automatic COLAs until 1975.

·         COLAs are based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

·         The calculation compares inflation during July through September from one year to the next.

·         Retirees often experience inflation differently than working households because healthcare represents a larger portion of their spending.

·         Alternative inflation measures such as CPI-E and the Chained CPI continue to be debated.

·         The 2027 COLA is currently expected to be approximately 2.5% to 2.7%, although the official announcement will not occur until October 2026.

Coming Next Week

Social Security Explained – Part 2

Why More Retirees Are Paying Tax on Their Social Security Benefits

We’ll explain how the taxation of Social Security began, why the income thresholds have remained frozen for more than 30 years, and walk through real-world examples showing why many retirees are surprised to learn that **61% of their benefits—not necessarily 85%—may be subject to federal income tax.

How Otium Financial Planners Can Help

Understanding your Social Security benefits involves much more than knowing what your monthly check will be. Decisions about when to claim benefits, how inflation may affect your retirement income, how benefits are taxed, and how Social Security fits into your overall financial plan can have a lasting impact on your retirement security.

At Otium Financial Planners, we help individuals and families build personalized retirement income strategies that coordinate Social Security with investments, tax planning, Medicare decisions, and long-term financial goals. If you’d like to discuss how Social Security fits into your retirement plan, we’d welcome the opportunity to meet with you.