Social Security: The impact of a chained CPI switch

We’ve been hearing about the imminent demise of Social Security for so long that many younger people have written it off as a part of their retirement planning. In that sense, the White House’s recent proposal to move Social Security’s cost-of-living adjustments over to what’s known as chained CPI, thereby reducing the annual increases, can be seen as a minor move.

And that’s far from the only bad news that has befallen Social Security hopefuls. The Social Security Board of Trustees now projects that the trust funds will be exhausted in 2033, which means payouts will be limited to the amount brought in by the concurrent payroll taxes. At that point, the conventional wisdom is that benefits will fall by about 25 percent — unless Congress intervenes sometime in the next 20 years.

Given that Social Security’s been under assault for so long, many advisors are understandably blasé about moving to chained CPI; it could be seen as chipping away at something that’s dying anyway. But Social Security has a much bigger impact on the elderly than is commonly discussed. It’s still a cornerstone of a lot of retirement planning, and for good reason: under the right circumstances, it can be worth a million dollars.

“Social Security, if you plan for it correctly, should be a million-dollar asset and should be accounted for and planned for very prudently,” says Ron Floyd, a managing director with the Hunter Group in San Diego. “You’re looking at a $30,000 per year asset. Let’s say there’s 2 percent inflation, and you’re into retirement for 25 years. Those numbers get very big.”

But that’s with the traditional adjustments based on the consumer price index. Chained CPI will have a subtle but noticeable effect on everyone who gets Social Security. Rather than simply adjusting everything for inflation, chained CPI takes into effect how consumers adjust to higher prices. For instance, if the price of steak goes up by 10 percent in a year, that part of the consumer price index would rise by 10 percent under the existing system. Chained CPI would note that people would react by buying more chicken, and the cost of living increase might drop to 5 percent.

It’s a much more complicated way of figuring inflation, and will be prone to hiccups. Currently, there’s an annual inflation adjustment applied to Social Security, but chained CPI can take years to figure properly. If Congress does try to apply chained CPI on an annual basis, there will likely be subsequent revisions and corrections — meaning the retired could see their benefits decline on occasion when those adjustments are made.

More significant is how the effects of chained CPI will develop over the years. It’s like the magic of compound interest, except in reverse. Let’s say someone is getting $2,000 a month in Social Security benefits. With a 2 percent inflation adjustment, they’d get $2,040 per month in the second year, and $2,438 in 10 years. Knock that down to 1.5 percent in chained CPI, and it doesn’t seem like much difference initially, just $10 less per month in the first year. But by year 10, it’s grown to just $2,321.08, a difference of $116.92 per month, or more than $1,400 per year.