Social Security COLA

The Social Security cost-of-living adjustment, or COLA, is the automatic annual increase applied to Social Security and Supplemental Security Income benefits so they hold their value against inflation. It is set by law rather than by discretion: the Social Security Administration compares the Consumer Price Index for Urban Wage Earners and Clerical Workers (the CPI-W) for the third quarter of the current year with the same quarter of the last year in which a COLA took effect, and the percentage increase becomes the next year's adjustment. The agency announces the figure in October, and the raise takes effect with benefits payable in January. The current COLA is 2.8%.

The mechanism is fixed in statute, at 42 U.S.C. 415(i), which is why the COLA is automatic and not a yearly political decision. The index used is the CPI-W, a measure of prices faced by working households, and the comparison is quarter-to-quarter: the average CPI-W for July, August, and September of the current year against the same three months of the prior year that produced a COLA. If prices rose 2%, benefits rise 2%. If the index does not rise, there is no COLA that year and benefits simply hold flat, which has happened in a few years, but benefits are never cut by a COLA. Two features surprise people. First, the increase compounds. Each year's COLA is applied to a benefit that already reflects every prior COLA, so a long retirement can see the starting benefit grow substantially over time, and the compounding is one reason delaying a claim, which raises the base the COLA is applied to, has lasting value. Second, the COLA is applied to the primary insurance amount and flows through to benefits derived from it, so a spousal or survivor benefit rises with the worker's record, and the adjustment continues after a person has claimed rather than being locked in at the claiming age. The COLA is often criticized on the ground that the CPI-W tracks the spending of working-age wage earners rather than retirees, who spend more on health care, where prices have often risen faster. An alternative index built for the elderly, the CPI-E, has been proposed for this reason but is not the measure the law uses. The debate does not change how the current adjustment is computed; it is a policy argument about which index is fairer, not a description of the rule in force. The COLA also indirectly moves other Social Security figures, such as the taxable wage base and the earnings test limits, which are recalculated each year in step with wage and price growth.

The COLA turns a price-index change into a percentage raise applied to benefits. Each October the Social Security Administration measures the change in the CPI-W from the third quarter of the prior COLA year to the third quarter of the current year, sets that percentage as the COLA, and applies it to benefits payable beginning in January. The raise carries forward, so it becomes part of the base on which the following year's COLA is figured. A hypothetical example shows the compounding, using a made-up 2% adjustment rather than the current figure so the arithmetic stays fixed. Suppose Dorothy receives $2,000 a month and a 2% COLA takes effect. Her benefit rises by $40, to $2,040. If the next year's COLA were also 2%, it would be applied to the $2,040, not the original $2,000, adding about $40.80 rather than $40, so her benefit would become roughly $2,080.80. Over many years those compounding increases add up, which is why a higher starting benefit, such as one earned by delaying a claim, produces a larger dollar raise every year thereafter. The current legal adjustment is 2.8%; the 2% here is only for illustration.

Pros

• Protects the purchasing power of Social Security benefits against inflation automatically, without any action by the recipient.
• Compounds year over year, so the protection strengthens over a long retirement.
• Flows through to spousal and survivor benefits, which rise with the worker's record.

Cons

• Based on the CPI-W, which reflects working households rather than retirees, so it may understate the inflation retirees actually face, especially in health care.
• In a year when the index does not rise, there is no increase at all, even if specific costs important to retirees have gone up.
• A larger COLA can push more of a beneficiary's income into the range where benefits become taxable or Medicare premiums rise.