Social Security is often touted as a guaranteed, lifetime, inflation-protected income stream that retirees should milk for all it’s worth. While it does last a lifetime – and there are plenty of ways Congress might address the projected shortfall – the program probably won’t stand up to inflation the way many retirees hope it will.
Social Security’s Board of Trustees recently forecasted a 2.2 percent COLA for 2018 – by far the largest adjustment in the last few years and a seemingly significant improvement over 0.3 percent in 2017 and 0 percent in 2016. As the AARP pointed out, however, 2.2 is still a relatively small increase that will do little to nothing in the face of rising prices on health care and consumer goods.
Looking at the issue over a longer time horizon, it may not be wise to count on the COLA to preserve Social Security’s spending power for your clients. It’s a powerful income stream, no doubt, but given the health care crisis, rising food and energy costs and the ever-increasing longevity risk of today’s retirees, they’ll likely need an additional funding source in the future.
How the COLA is calculated today
Inflation protection wasn’t an original feature of Social Security; until 1975, Congress enacted every increase with special legislation. Since automatic annual COLAs began with the 1972 Social Security Amendments, rates have gone as high as 14.3 percent and as low as zero.
Where does the Social Security Administration get those numbers?
“The Bureau of Labor Statistics looks at how much the general cost of living expenses go up – not in the past year, but only in the third quarter of the past year,” says Gail Buckner, National Financial Planning Strategist with Franklin Templeton Investments.
The price fluctuations we see in July, August and September of each year, then, are reflected in beneficiaries’ checks in January of the following year.
“We had that zero percent increase in 2016 just because in the third quarter of 2015 there was a drop in specific prices – even though oil prices and everything else went up in the other three quarters,” adds Buckner.
The CPI-W and alternatives
More specifically, the COLA is tied to the third-quarter percentage increase in the CPI-W, the consumer price index for urban wage earners and clerical workers. The CPI-W prioritizes items purchased by metropolitan workers, including food, clothes, transportation and entertainment.
That metric is under fire for a couple of reasons. First, critics say it doesn’t reflect the true rate of inflation on the goods and services that impact consumers the most.
“They’ve redefined inflation in a way that shows it’s low,” says Bill Stack of Stack Financial Services. “What the government is looking at might go up 1 or 2 percent, but what everyone is really purchasing is going up a lot more than that.”
Second, even if the CPI-W did accurately reflect workers’ purchases, it doesn’t account for the costs that specifically impact retirees – namely housing and health care. Health care inflation alone has outpaced the CPI for over a decade, and while insurance premiums certainly reflect the increase, the COLA does not.
One proposed solution is the CPI-E, the Experimental Price Index for Elderly Consumers, which tracks the spending of Americans 62 and older. The CPI-E puts more weight on health care and housing, but “when you look at how it tracks against the CPI-W, there hasn’t been a massive difference,” says Martin Cowley, LifeYield Executive Vice President.
While separate sectors of the federal government manage Social Security and Medicare, there is an important interplay between the COLA and Part B premiums. Social Security’s “hold harmless” provision stipulates the COLA can never be negative, and the Medicare code says the Part B premium increase can’t be higher than the COLA dollar amount.
Post-deduction benefits, then, won’t decrease year to year, but whatever COLA a beneficiary might enjoy can easily be eaten up by that year’s Part B increase. Inflation still takes its toll, of course, leaving these retirees with less spending power year after year.
Just as importantly, the hold-harmless provision doesn’t apply to clients with household incomes over the first-tier Part B threshold – $85,000 in 2017.
“If you had net income less than that, you saw no increase in your Medicare premium last year,” says Buckner. “On the other end, if your income was greater than $214,000, you saw your premium go up by $268 to a total of $389.”
Ultimately, rising health care costs have to be reflected somewhere in the Part B premiums. Roughly 75 percent of beneficiaries fit into the bottom income tier, and with the hold-harmless provisions in place, high earners will be left to absorb the increase via the high-income surcharge.
Takeaways for clients
Despite an ineffectual COLA, Social Security is still a powerful income stream that seniors should strive to maximize. “We always look at it as a foundation you build on, and it’s more important than ever to get that foundation right by delaying,” says Cowley. Given the gradual decrease in spending power, however, most clients will need to set aside extra funds to cover both health care costs and day-to-day expenses.
Their options? “It’s not available to everyone, but more companies are offering HSAs,” says Buckner. “I would tell advisors with clients in their 50s to have them max out their HSAs now to provide a buffer against unexpected health care expenses later on.” With tax-free contributions, growth and distributions, the HSA is a solid choice for any investor who has a high-deductible health plan, and who is already contributing up to their employer’s 401(k) match.
Fixed index annuities with income riders can also bolster Social Security’s lifetime payouts without risking principal.
“Lots of people say you need to stay invested in the stock market, but most seniors can’t handle the risk of a downturn when they’re drawing income every month,” says Stack. “These products give retirees the ability to hedge against inflation while also keeping their principals safe.”
Useful as these products are, most clients won’t know to ask about them. Retirement is getting more complicated, and clients increasingly need specialized products and strategies to hedge against longevity risk in an environment of rising health care costs and inflation. That’s where you can step in and add value.