Financial Advice

How Cost of Living Adjustments are Calculated

How Cost of Living Adjustments are Calculated

When you file for Social Security benefits or Supplemental Security Income (SSI), your lifetime earnings determine the amount of your monthly retirement benefit. However, this number is not static for the rest of your life.

Your social security benefits will increase over time to keep pace with "inflation" or the cost of living. In other words, your retirement benefits will be affected by an annual process, referred to as the cost-of-living adjustment, or COLA.

Congressional legislation authorized cost-of-living adjustments in 1973 and put it into practice in 1975. With these adjustments, SSI and Social Security benefits stay current with inflation to help retirees keep pace with their living expenses. Before 1975, only legislation led to changes for social security benefits.

Impact of COLA on Social Security Benefits

Cost-of-living adjustments are made based on measurements of inflation. When inflationary pressures are present, Social Security benefits adjustments get made in subsequent years. If there are no measurable changes, no COLA is applied.

Because COLA depends on inflation, an increase does not occur every year. However, Social Security benefits will be increasing in 2023.

Beginning with the December 31st, 2022 benefit, payable in January 2024, and continuing until the next COLA in October 2024, a COLA increase of 3.2 percent will be reflected in the SSI payments made to Social Security benefit recipients.

As an example, if you received $1,724 in monthly Social Security benefits last year, and this year's COLA is 8.7 percent, your monthly benefits for the coming year will be $1,779 ($1,724 x 1.032).

How COLA is Calculated

Cost-of-Living-Adjustments uses the Consumer Price Index (CPI), the official measurement of inflation used by the U.S government. The Consumer Price Index measures the prices of over 80,000 services and goods.

Cost-of-living adjustments are made based on the CPI as specified by the Social Security Act. Specifically, Social Security adjustments use the CPI's Urban Wage Earners and Clerical Workers (CPI-W) measurement. The Bureau of Labor Statistics calculates CPI-W's monthly.

Issues with COLA Calculation Method

There are several concerns with how the Social Security Administration (SSA) estimates the average cost of living adjustments. First, the index the SSA uses only accounts for 32 percent of the total population's spending habits, even though a newer index can evaluate 87 percent of people's purchasing habits. In addition, the 32 percent represents a younger "wage earner" demographic, which is different than seniors or the elderly who receive social security benefits.

Second, the CPI measurement used for determining Social Security benefits adjustments does not consider shifts in consumers' spending habits when prices change. As an example, increases in the price of gasoline may transition consumers to use mass transit more regularly. The CPI does not reflect that spending shift. As a result, inflation's impact might not be as meaningful, and it might not be needed to alter benefits.

Third, some say the current method does not account for costs, such as out-of-pocket health care costs, that affect seniors the most. Therefore, they feel price indexes should be changed to more accurately measure senior spending.

Congress has not instructed the Social Security Administration to derive a more accurate CPI to date. However, Congress can base COLAs on different measurement methods in the future. Since the Social Security Act may be nearing the point of needing a revamp, changing the way to calculate COLA is possible and could be part of any reform package.

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