Social Security: What is COLA and How Does it Work?

The Social Security Administration (SSA) is required by law to prevent inflation from eroding the purchasing power of benefits paid to recipients. They do this by making cost-of-living adjustments (COLA), which are automatic increases in benefit amounts.

In this post, we’ll review how COLA is calculated, highlight some historical data, and show why—even with COLA—the purchasing power of Social Security has declined.

How COLA is calculated

Cost-of-living adjustments are based on the Consumer Price Index (CPI-W), which tracks retail prices as they affect urban hourly wage earners and clerical workers. The Bureau of Labor Statistics calculates these adjustments on a monthly basis, with the Social Security Administration then announcing them every October. Recipients typically see the benefit beginning in January of the following year.

COLA increases are not guaranteed, and COLA is never negative. With respect to how the program works, Social Security benefits increase if there is a measurable increase (0.1 percent or higher) in the price index from year to year, or, more specifically, between average prices in the third quarter of the current and previous year.

For example, after Q3 2021, the average CPI-W was 268.421. During this same period for 2022, the CPI-W was 291.901: representing an increase of 8.7%. As a result, Social Security recipients are receiving a cost-of-living increase of 8.7% in 2023: the largest increase in more than 40 years!

History of COLA increases by year

Initially, Social Security benefits only increased when Congress enacted special legislation; but when Congress enacted the COLA provision in 1972, annual COLAs commenced in 1975. However, the law provided for automatic increases only if the Consumer Price Index rose by at least 3 percent. In 1986, Congress eliminated the 3-percent trigger: allowing for COLAs to be tied to the consumer price index.

Since then, benefits didn’t increase at all during only three years: 2010, 2011, and 2016. The biggest increase (in 1981) triggered a 14.3% increase for Social Security recipients.

COLA in the 1900s

COLA in the 2000s

Chart Sources: Social Security Administration

COLA and purchasing power

COLA may sound great on paper, but in actuality, the purchasing power of Social Security has actually eroded. That’s because the CPI-W underweights specific sectors that experience very steep prices: including prescription drugs, homeowners insurance, property taxes, and fresh fruits and vegetables. What’s more, different indexes measure Medicare and Social Security adjustments—resulting in a faster rate of increase for Medicare premiums. For example, between 2000 and 2018, Social Security COLAs averaged a 2.2% annual increase: considerably less than the 6.1% annual increase in standard Medicare Part B premiums. While the hold harmless provision (a law that prohibits Medicare Part B premiums from reducing the amount of your Social Security benefits) protects some beneficiaries, it doesn’t cover everyone and is far from perfect.

According to the Senior Citizens League—one of the nation’s largest nonpartisan seniors groups—Social Security benefits have lost 40% of their buying power since 2000. The League states that while COLAs increased Social Security benefits by 64% between January 2000 and March 2022, the cost of goods and services purchased by typical retirees rose over 130% during that same period.

In sum: COLA and its impact on Social Security

One way to think of COLA is like a raise in your Social Security paycheck. Although this “raise” is meant to cover the cost of inflation, it rarely does. Consequently, you’ll need to plan for inflation in retirement. 

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Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.