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November 12, 2013

Chained CPI Could Mean Big Social Security Cuts in Long Term

In order to stem the growing deficit and potentially create a more accurate cost-of-living adjustment (COLA) calculation, many congressional representatives have promoted use of the so-called “chained” consumer price index (CPI).

Unlike the current CPI, the chained CPI accounts not only for price increases, but also for the substitutions consumers make based on those increases.

“For example, if beef prices are increasing, the chained CPI assumes that to some extent, consumers will switch to chicken and use comparable goods to stave off increases,” said James Osborne, president of Bason Asset Management. “The end result is that there would be a smaller COLA due to a lower calculated rate of inflation.”

Of course, a consistently lower COLA would lead to lower annual increases in Social Security benefits, and the AARP is lobbying to prevent the change. In a letter to the Ways and Means Committee, the organization stated that “Despite claims to the contrary, the chained CPI is not a more accurate measure of inflation, especially for Social Security COLAs. In fact, it is even less accurate than the current formula.”

Even the current COLA calculation, which is based on the Consumer Price Index for Urban Wage Earners and Clerical Workers, doesn't accurately reflect the needs and spending habits of retirees, the long-term disabled and other Social Security recipients, according to AARP. While the prices of food and other common consumer goods are roughly in line with inflation, health care and long-term care costs have risen far faster, and seem to be rising still.

While some proponents of the chained CPI argue that it is a more accurate means of gauging inflation, cutting the deficit seems to be Congress' primary incentive for the change. “If you're Congress, the purpose of switching to the chained CPI is explicitly to slow the growth of benefits,” said Osborne. “It's not really an issue of accuracy, it's a budgetary move.”

Despite the AARP backlash, the chained CPI may also be one of the most politically feasible measures for entitlement-related spending cuts. “If Congress is looking for long-term ways to reduce benefit outlays, this is a politically easy thing to do, in part because nobody understands it, and in part because it's a long-term game,” Osborne said. Though 87% of AARP poll respondents said that Social Security benefits should not be reduced, the gradual effects of a CPI change will likely garner less outcry than a retirement age increase or additional taxes on benefits.

As the AARP was quick to point to out, the chained CPI would most negatively affect long-term Social Security recipients. “Although many have attempted to characterize the chained CPI as a minor tweak, it is in fact a significant benefit cut that snowballs over time,” AARP stated in its letter. A recipient who started collecting $1,100 per month at age 65, a 0.3% annual cut in the COLA would lead to $56 monthly reduction at age 80 — a significant amount for a family depending on the program for most or all of their retirement income, according to AARP.

Osborne agreed, saying “It's definitely going to be a compounding, exponential change. Nobody is going to tell the difference between a 2% and a 1.7% COLA in a year or two, but if you compound those numbers out over 20 years, it does become more substantial.” While the chained CPI may not affect those already late in retirement, it could significantly affect the degree to which soon-to-be retirees can depend on Social Security.

This content has been developed by a third party not affiliated with Nationwide Financial and is made available for informational purposes only. This information does not constitute a recommendation nor should be construed as a solicitation to purchase any investment product. Nationwide Financial and Summit Professional Networks are non-affiliated companies. Nationwide, Nationwide Financial and the Nationwide framemark are service marks of Nationwide Mutual Insurance Company. ©2014 Nationwide Financial Services, Inc. All rights reserved.

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