Financial economists are in love with the idea of an inflation-indexed annuity because it eliminates two of the most important risks in retirement — inflation and outliving assets. A retiree gets an income that never runs out and provides the same lifestyle each year.
The only remaining provider of inflation-protected annuities in the United States is the federal government through Social Security. Retirees today can buy more of this income by waiting until age 70 to claim Social Security, thereby boosting their inflation-protected income by 30% over their full retirement age.
For healthy, higher-income retirees who have seen the largest improvements in longevity in recent decades, this increase in lifetime inflation-protected income appears to be a bargain.
In fact, inflation protection means that the value of $2,000 in Social Security income at age 70 is greater than receiving $2,300 in a lifetime nominal pension (that will not rise with inflation).
The inflation protection provided through Social Security is an often overlooked but important benefit that makes it a valuable tool for funding basic retirement expenses.
How are Social Security benefits adjusted for inflation, and can we expect these annual income increases to continue in the future? Does the inflation adjustment do a good job of increasing income when retirement expenses rise?
The expected shortfall in the Social Security trust fund means that policymakers will soon be looking for ways to shore up the system’s finances. Reducing inflation adjustments offers the dual political benefit of avoiding a reduction in size of Social Security checks and reducing the size of future payroll tax increases.
Should advisors be worried that this important benefit will disappear?
The Importance of Automatic Social Security COLAs
Social Security recipients will receive a 1.3% cost-of-living adjustment (COLA) to their monthly benefits beginning in January 2021. The average Social Security retirement benefit in 2020 is around $1,500.
Therefore, the “average” retiree will receive approximately a $19.50 increase in their monthly benefit check, or $234 for the year. This increase is on top of the 1.6% increase for 2020.
Social Security benefits only rise when prices go up; in years with low price inflation, they remain steady.
Protection against the erosion of purchasing power is particularly important today as people are living longer than ever before and rising health care costs often lead to unexpected expenses that can drain savings in retirement.
In order to keep inflation from eroding purchasing power, benefits are purposefully designed to increase with price inflation and without political interference.
Legislation enacted in 1972 required that beginning in 1975, future cost-of-living adjustments to Social Security and Supplemental Security Income (SSI) benefits be tied to the Consumer Price Index. This also ensures that COLAs do not require yearly congressional action and are not tied to the direction in which the political winds blow.
How Are Social Security COLAs Determined?
The Social Security Act specifies that any COLA be based on the percentage increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) from the third quarter of the previous year to the third quarter of the current year.
If a COLA is warranted, it shows up in benefit checks beginning the following January. If there is a decrease in the CPI, or deflation, no COLA is provided.
Further, no COLA can occur in subsequent years until the CPI exceeds the previous high point. This is why there was no COLA in 2010, 2011 and 2016.
Can Social Security Benefits Decrease?
Though benefits can increase, it is important to note that Social Security benefits never decrease, even during periods of deflation and a decline in the CPI.
Even though the United States is currently experiencing high unemployment, low economic growth and record high levels of national debt because of the pandemic, Social Security benefits appropriately increase purchasing power for retirees.
In some years, the COLA can be quite large. For example, the COLA for 2009 was 5.8%, the largest increase since 1982.
However, this larger than normal COLA in 2009 was primarily a result of significant increases in the price of gas and energy during the spring and summer of 2008, when prices for gasoline reached $4 per gallon.
In other years, the COLA can be low or even 0%. In 2010 and 2011, there was no COLA for Social Security beneficiaries after gas and energy prices declined, resulting in a lower CPI.
If there is a decrease in the CPI (or even deflation), no COLA is provided and no COLA can occur in subsequent years until the CPI exceeds the previous highest level. This is why there was no COLA increase in 2010, 2011, and 2016.
Medicare Premiums and Social Security COLAs
Many Social Security beneficiaries also rely on Medicare to cover their health costs. Medicare Part B and Part D premiums are automatically deducted from beneficiaries’ Social Security benefits.
In the absence of a COLA, however, Medicare Part B premiums are not allowed to rise for most Social Security beneficiaries.
While Medicare helps pay for many health-related costs, such as doctor visits, inpatient hospital care, nursing care, medical services and devices, it does not cover long-term care.
CPI-W vs. Chained CPI
The Consumer Price Index (CPI) measures the average change in prices paid by consumers for a market basket of consumer goods and services. Since budget shares differ among consumers, there are indexes built to weight components of the market basket differently.
For example, the most common measure of price inflation is the CPI-U, Consumer Price Index for All Urban Consumers. Social Security uses the CPI-W (Consumer Price Index for Urban Wage Earners and Clerical Workers).