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How Social Security COLAs Are Calculated

I often get asked the question, "What is the Social Security cost of living adjustment (COLA)?" This question usually follows it: "How is it calculated?" Social Security benefit checks are impacted by these year-to-year adjustments, so I understand why my clients ask these questions.

To learn more about COLA, I went to the reference page on the Social Security website, Cost-of-Living Adjustment (COLA) Information for 2018. The first part of the page shows the 2018 COLA adjustments. To read more about it, here is a 2018 Fact Sheet. (For more, see: 5 Social Security Changes to Expect in 2018.)

A Brief History of COLAs

President Richard Nixon signed into law the H.R. 1, the Social Security Amendments of 1972. Congress debated for three years before coming up with the final bill. There were several provisions added to Social Security in H.R. 1.

Some of the other provisions introduced were changes to the retirement test, assuring working longer resulted in higher benefits. It created a minimum benefit amount for those who worked at lower wage jobs. Also, it brought higher benefits for those working beyond age 62.

Beginning in 1975, automatic annual cost of living allowances became part of the Social Security provisions. Before this change, Congress decided if, when and how much COLAs would be. Now, they get calculated based on a Consumer Price Index (more on that later). The Social Security Administration (SSA) assesses this measure in October each year and announces COLAs for the following year.

You can see the history of these increases (or lack thereof) at the bottom of the page referenced earlier. With the low inflation of the last few years, increases have been quite low. In fact, there was no increase for 2016. Here are the COLAs for the last several years:     

  • 2013: 1.7%       
  • 2014: 1.5%       
  • 2015: 1.7%       
  • 2016: 0.0%       
  • 2017: 0.3%       
  • 2018: 2.0%

How COLAs Are Calculated

The SSA calculates COLAs based on the Consumer Price Index (CPI-W) increase from the third quarter of each year. They announce those changes in October of each year for the following year. Intense debate continues whether the CPI-W is the correct measure to use in the calculation. According to the Bureau of Labor Statistics' website, the CPI-W index is meant to "track retail prices as they affect urban hourly wage earners and clerical workers." The CPI-W covers around 37% of the workforce. (For more, see: Maximize Your Social Security Benefits.)

The CPI-U, according to the Bureau of Labor Statistics, is "a more general index and seeks to track retail prices as they affect all urban consumers. It encompasses about 87% of the United States' population." One of the major criticisms of the CPI-W index is that it dramatically underestimates healthcare costs. For senior citizens, that represents a much more significant percentage of expenses than the working population. This page  on the Social Security Administration's web site shows annual cost of living adjustments since 1975.

Other Changes Announced Each Year

In addition to the announcement of the COLAs, the October announcement includes several other changes. One is the income on which we pay Social Security taxes. Like with COLAs, this may or may not change each year. However, it gets included in the list, even when there is no change. Some of the other things announced are FICA and Medicare tax rates, disability thresholds and maximum benefit amounts.

If you are working while receiving Social Security benefits, the SSA applies an earnings test to see if your Social Security income becomes taxable. There is a limit to the income you can earn before they get taxed. Those income thresholds are also part of the annual October announcement.

Navigating the Rules

The Social Security rule book contains over 2,700 rules. It’s virtually impossible for anyone to know them all. The SSA website is an excellent place to get your questions answered about benefits. It’s always best to educate yourself before going to your local SSA office or calling them on the phone.

Rule changes in November 2015 brought more confusion and complexity to the rulebook. I’ve heard horror stories from clients and others who got the wrong information from SSA personnel. They do the best they can and, in general, are very good. However, it’s impossible for anyone to keep track of all the rules.

Trying to navigate this journey on your own may prove to be a nightmare. There are good software options available to help you calculate the optimal claiming strategy based on the current rules. Good financial advisors should be well versed in this area to guide you through the maze. Don't be afraid to ask for help. (For more, see: How to Manage Lower Social Security Adjustments.)