How Social Security’s COLA’s work

From Retirement Now Newsletter October 14th, 2021

I came across a good article on Social Security cost of living increases that I thought you (and the HWA community) might want to hear about. Especially since they will soon release what the increase is going to be for 2022. In fact, one report said the information should be released Oct 13th, so by the time you receive this newsletter you may already know what it will be.

Nevertheless, the article is from InvestmentNews titled “How COLA affects Social Security benefits.”

According to the article, the increase for 2022 is expected to be one of the biggest on record and one financial advisor was wondering if they should encourage their clients to start claiming Social Security now in order to be eligible for this expected large increase.

But that is not necessary because people still benefit from the cost of living increase even if they aren’t drawing benefit yet.

The article breaks down how COLA’s impact Social Security in 5 points.

The first point is that you are eligible for annual cost of living adjustments once you reach age 62, even if you don’t file for benefits up to age 70. The COLA will increase your primary benefit amount as measured by the consumer price index.

But what about price increases before you reach age 62?

That brings us to the second point…

Social Security benefits are based on a person’s average lifetime earnings taking the top 35 years worth of earning, then it indexes those earnings to account for changes in average wages. This acts as something of an inflation/COLA increase. The Social Security Administration (SSA) will use these indexed average earnings to determine what your full retirement age benefit would be.

Point number three: If you choose to collect benefits before your full retirement age SSA will reduce those benefits permanently. If you delay beyond your full retirement age they will increase your benefits 8% for each year beyond up to age 70.

Point number four is …

The COLA is calculated based on the rise in this year’s 3rd quarter CPI compared to the prior year’s CPI. Which means the CPI data for July, August, and September will determine what the increase is going to be.

That’s why they announce the COLA in October. They’re waiting for the data to come in.

And the last point is a really interesting one.

Since Social Security determines COLA’s based on changes in 3rd quarter CPI it can cause some interesting increases. For instance, in 2009 there was a temporary spike in gasoline prices that cause the CPI in that quarter to look much higher than that prior year’s CPI. This caused the COLA for 2009 to be 5.8%. This was something of an anomaly as gas prices returned to normal. But the return to normalcy was not reflected because SSA only looks at what happens in the 3rd quarters.

As a result of this abnormally high COLA, once prices returned back to normal it took another 3 years before 3rd quarter CPI exceeded prior quarter’s CPI. In 2010 and 2011 there was no cost of living adjustment. The next COLA was in 2012.

This same thing may happen again this year. Here’s my thoughts on why…

With lockdowns and travel restrictions in 2020 I believe this kept prices lower as people had less legal opportunity to spend money. Now that things are opening up again, there is more demand, perhaps even pent up demand.

So higher demand on one end. And on the other end, reduced supply may be causing some prices to go up. For example, think about the chip shortage that is keeping as many new vehicles from coming on to market, and how that is driving up the price of used vehicles.

That is just one example.

And if SSA only compares 3rd quarter CPI, last year may have been artificially low and this year’s may be artificially high, causing a bigger COLA increase than normal.

And it’s possible that COLA’s in the following years may not be as big, or occur at all. Kind of like what happened in 2010 and 2011 after the big COLA of 2009.

Time will tell.