Maximize Your Social Security Benefits

By Rich White AAA

Millions of retired (or soon-to-retire) Americans face the same great financial challenge: how to maintain a quality standard of living over a longer lifespan. Among several variables that make planning for this challenge difficult, inflation is in a class by itself. High rates of inflation can wreck the best-laid plans of retirees. Fortunately, the vast majority of retired Americans have a powerful inflation-resistant ally on their side: the annual cost of living adjustment (COLA). This ally has more than 30 years of proven experience, and not once has it failed to maintain the purchasing power of U.S. Social Security retirement benefits. Read on to learn more about how it works, and how it could affect your retirement income.

A COLA Milestone
In each year since 1975, the Social Security Administration (SSA) has automatically increased all retirement benefits to maintain dollar-for-dollar purchasing power parity with the Consumer Price Index (CPI). Since the COLA is uncapped, it has protected retirement purchasing power dollar for dollar, even in the most devastating era of inflation in modern U.S. history, the years from 1979 to 1982.

The SSA calculates the COLA by comparing the average index value of the CPI for July, August and September of each year with data from the same period in the prior year. It then adjusts all retirement benefits upward by the resulting percentage increase, starting with the checks distributed in December of the current year.

How the COLA Has Inflation-Proofed Social Security Income

Figure 1: Social Security cost of living (COLA) adjustments, 1975 through 2012
Source: SSA.gov

This table shows the monthly maximum Federal SSI payment amounts for an eligible individual, and for an eligible individual with an eligible spouse. In 2008, for the first time, inflation-adjusted benefits was more than four times the benefits paid in 1975, the first year of the COLA. For today's 95-year-old, the COLA has produced $3 of current retirement income for every $1 of original benefit!

Note: There is no COLA increase for years in which there is no increase in the Consumer Price Index. 2010 was the first time in history that there was no increase.

Benefits Built into the COLA
Congress created a forerunner of the modern COLA in 1962 to keep retirement annuities paid to federal workers in line with inflation. Under 1972 legislation, the COLA was extended to Social Security benefits and automatically linked to annual changes in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), starting in 1975. Over time, Congress has tweaked the formula for calculating the COLA a few times, but its basic benefit has not changed.

One way to quantify the potential value of Social Security benefits is on a "retirement plan equivalent" basis. In other words, how much money would it take in a 401(k) plan or IRA to produce the same after-tax income that Social Security provides (under current law)? In the analysis that follows, we will answer that question by assuming no changes in the current formula for calculating Social Security benefits or the COLA. The example assumes:

  • A couple begins Social Security with first-year combined (his/her) benefits of $40,000. The maximum benefit payable at full retirement age in 2008 was $2,033 per month ($24,396 per year). Assuming both husband and wife qualify for benefits on their own work records, $40,000 in combined benefits equals about 80% of the maximum, so it is realistic.
  • They each live an additional 25 years. The COLA averages 3.5% per year, and a 5% discount rate (annual cost of money) is assumed for present-value analysis purposes.
  • To compare Social Security benefits to retirement plan money (with 100% taxable distributions), we have assumed that 50% of Social Security benefits are taxable at a 30% combined federal/state tax rate. Retirement plan distributions also are assumed to be taxed at 30%.

Results are shown in the table below:

Year Combined
Benefits with 3.5% COLA
Present
Value of Benefits @ 5%
After- Tax Present Value Retirement Plan
Equivalent
1 $40,000 $38,095 $32,381 $46,259
2 41,400 37,551 31,918 45,598
3 42,849 37,015 31,462 44,946
4 44,349 36,486 31,013 44,304
5 45,901 35,965 30,570 43,671
6 47,507 35,451 30,133 43,047
7 49,170 34,944 29,703 42,432
8 50,891 34,445 29,278 41,826
9 52,672 33,953 28,860 41,229
10 54,516 33,468 28,448 40,640
11 56,424 32,990 28,041 40,059
12 58,399 32,519 27,641 39,487
13 60,443 32,054 27,246 38,923
14 62,558 31,596 26,857 38,367
15 64,748 31,145 26,473 37,819
16 67,014 30,700 26,095 37,278
17 69,359 30,261 25,722 36,746
18 71,787 29,829 25,355 36,221
19 74,300 29,403 24,992 35,703
20 76,900 28,983 24,635 35,193
21 79,592 28,569 24,283 34,691
22 82,377 28,161 23,937 34,195
23 85,260 27,758 23,595 33,707
24 88,245 27,362 23,258 33,225
25 91,333 26,971 22,925 32,750
Totals $1,557,994 $805,673 $684,822 $978,317

In this analysis, a total of $1,557,994 in Social Security benefits is projected to be received by the couple over 25 years. On a present-value basis (at a 5% discount rate), the value reduces to $805,673 in today's dollars. On an after-tax basis, the present value is $684,822. It would take $978,317 in retirement plans today to produce an equivalent after-tax income stream over the same period, assuming the retirement plan earns 5% annually and distributions are taxed at 30%.

Many people would be shocked to learn that their Social Security benefits have a greater present value than their 401(k)s or IRAs. To the extent that this potential exists, it is due largely to the fact that: 1) Social Security benefits are inflation-adjusted under current law, and 2) most retirement plan benefits are not inflation adjusted.

Of course, Social Security benefits (including the COLA) are not guaranteed by the U.S. government. So, before you put this money in the bank, you may want to consider what part of current benefits may be lost to future reforms aimed at keeping the system solvent. (For more insight, see How Much Social Security Will You Get?)

Maximizing the COLA's Value
Understanding the COLA's benefit is more than an academic exercise. It can affect critical Social Security decisions and even long-term retirement security. Assuming no changes in the law, COLAs keep compounding year after year. Therefore, they will have the greatest cumulative benefit in the final years of retirement. Here are a few guidelines for planning purposes:

  • For individuals reaching retirement age today, benefits can begin as soon as age 62 with a permanent reduction. Full benefits can begin at age 66 for those born between 1943 and 1954. To maximize the future value of COLAs, wait until you reach full retirement age to begin benefits. This will link a larger part of your total retirement income to the COLA and increase inflation protection in your retirement years.
  • Consider your personal health, family health history, dietary and exercise habits – all of which can be indicators of longevity. If you think there is a good possibility you may live to age 90 or more and you also are worried about higher inflation, don't automatically start Social Security benefits early. Maximize the COLA's old-age inflation protection instead.
  • Evaluate whether you have any other steady sources of retirement income that are inflation adjustable. For example, some pension plan payouts or annuities may be linked to the CPI, although most are not. For some retired people, Social Security is the only component of retirement income that has inflation protection.

A Caveat
The SSA observes that based on one provision of current law, the COLA could be reduced in the future, and that is "if the combined assets of the Social Security trust funds are below 20% of annual expenditures." The agency also notes that the combined trust fund assets at the beginning of 2007 were estimated to be 345.1% of expenditures, so there was no imminent danger of triggering this provision.

In summary, it's a good idea to have at least part of your retirement income inflation protected. Unfortunately, most people have few options available that can fulfill this goal – but they do have the COLA. To maximize the COLA's inflation-fighting ability, tie as much of your retirement income to it as you can.

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