Social Security is supposed to be inflation-proof. It’s anything but.
Today’s the day tens of millions of retirees learn about their annual Social Security “bonus.” I’m referring to the system’s COLA (Cost-of-Living Adjustment), which, as announced on Thursday, will raise recipients’ benefits by 8.7% starting with checks received in January.
The COLA is supposed to keep our (I’m also a recipient) benefits even with inflation. Unfortunately, it doesn’t. The COLA is calculated based on the rise in the Consumer Price Index between September 30th and October 1st of the previous year. Hence, we’re getting compensated for past annual inflation, with a three-month lag to boot! This leaves us perpetually behind the eight ball.
To see this, forget the three-month lag and suppose the COLA was calculated between January 1st and December 31st. Also, suppose that your benefit this January is $1,000 a month and that hot dogs in January cost $1 each (if purchased at the grocery store!). Now suppose the price of dogs rises by 100% between January 1, 2023 and December 31, 2023.
Then your $1,000 benefit will be worth 1,000 wieners in January, but only 500 wieners in December. On average, over the year, you’ll have received a monthly benefit of 750 wieners. Yes, starting in January 2024, your benefit will rise to $2,000. So, in that month, your benefit will again buy 1,000 dogs. But if the price level doubles yet again in 2024, you’ll, again, average just 750 dogs per month. If inflation continues to run at 100% annually, you’ll experience a 25% permanent real benefit cut in a program that’s supposed to be neutral to inflation!
In short, the lag in the inflation adjustment reduces our real benefits, with the reduction larger the higher the inflation rate. At a 10% inflation rate, you’ll go from a benefit of 1,000 dogs in January to 909 dogs in December. On average, that’s 954.5 dogs per month, meaning a real benefit cut of 4.55% over the year.
Gee, we’ve been running a roughly 10% inflation over the past year. So, all of us Social Security recipients have had our benefit cut, in real terms, by roughly 5%. (Ok, more like 4% if we calculate this more accurately.)
Earth to Congress, reform Social Security’s COLA so the adjustment is made monthly, not annually.
For many of us, our real benefit has dropped by even more. That’s because the inflation each of us experiences is different. The CPI is based on the increase in the cost of the basket of goods and services purchased nationwide. But our particular set of things on which we spend may have risen at a faster pace than products and services in general. I, for example, like, well used to like, frequenting restaurants. But menu prices I’m seeing seem to have doubled since COVID hit. Of course, I live in an urban area in New England, so restaurant price hikes near me may differ from those near you.
Inflation delivers another whammy for Social Security recipients. Our benefits are subject to federal income taxation (as well as state income taxation, albeit in only about a dozen states). The thresholds beyond which first 50% and then 85% of our benefits are subject to taxation are not indexed for inflation. Hence, with each year of inflation, particularly high inflation, more and more beneficiaries are having more and more of their benefits taxed away. Social Security’s nominal income-tax thresholds have been set in stone since 1983.
Earth to Congress — Index Social Security’s taxable income thresholds.
Another poorly understood issue with Social Security and inflation is its benefit calculation. The system indexes earnings prior to age 60 based on economywide average wage growth through the year we reach age 60. But covered earnings after age 60 are not indexed. Hence, in determining the average value of our highest 35 years of covered earnings, our post-60 nominal wages are ranked together with the pre-61 indexed earnings. With inflation, people working stand to experience a real benefit increase through what Social Security calls its recomputation of benefits, not because their real wages rose since age 60, but because their nominal wages (what they received in dollars) rose. Hence, if you had a low or spotty earnings history prior to age 60, this is the time to get back into the labor market to earn high nominal, if not high real wages. You may well raise your lifetime Social Security benefits by more than the additional FICA taxes you’ll pay!
Another thing about Social Security and inflation. If you’re waiting beyond full retirement age to start your retirement benefit, make sure you receive all your Delayed Retirement Credits (DRCs) and that they have been properly adjusted for the system’s COLAs. For example, if your benefit, had you taken it at 69, was $X, your benefit at 70 should be $X times 1.08 — to account for the year’s DRCs — times 1.087 — this year’s COLA. I’ve been hearing from people not receiving the right number of DRCs as well as receiving DRCs that aren’t properly inflation indexed.
Finally, if you have a nominal (non-inflation indexed) pension from non-covered employment, you can lose Social Security benefits equal to, at most, half of your non-covered pension due to the Windfall Elimination Provision (WEP). But, in real terms, this maximum loss falls with inflation. So inflation for those being severely hit by the WEP is a good thing. The same is true for those losing all of their spousal, widow, divorced spousal, or divorced widow benefits under the Government Pension Offset Provision (GPO). With enough inflation, those losing all of these benefits due to the GPO will suddenly find they are starting to receive a portion of these benefits. This assumes Social Security gets things straight — a huge assumption.
To understand what benefits you are really do and how much you are being zapped by Social Security’s delayed inflation adjustment, check out my company’s personal financial planning tools. Links are at kotlikoff.net.