Business & Economics

Why Social Security’s Exceptionally Large Cost-of-Living Adjustment Matters

It’s a reminder of how much Social Security beneficiaries depend on the program and how much they will lose if lawmakers don’t act soon to stabilize its finances

The new cost-of-living adjustment is a reminder of why we need to fix Social Security’s precarious finances. Image Credit: richcano/Getty Images

On Oct. 13, the Social Security Administration announced that program beneficiaries would receive their largest cost-of-living adjustment (COLA) in more than four decades: an increase of 8.7%. The COLA will take effect at the end of this year and determine benefit levels paid throughout 2023.

This year’s exceptionally large COLA is of great significance for Social Security beneficiaries and for the program as a whole. It should serve as a wake-up call to federal lawmakers, a reminder of how much beneficiaries would lose if the program were to go insolvent, which is exactly where things are currently headed. Here’s what you need to know about the COLA and the policy issues surrounding it.

The COLA Attempts To Make Up for Recent Price Inflation

Everyone who is already receiving Social Security benefits when the new year begins will receive the COLA: not only “old-age insurance” (often referred to as retirement) beneficiaries, but also other recipients including disabled individuals, non-working spouses, widows/widowers and child survivors. Although technically not part of Social Security, the Supplemental Security Income (SSI) program is also administered by the Social Security Administration, and its beneficiaries will receive the COLA as well.

Protection against price inflation is one of the most important features of Social Security. Without it, the purchasing power of enrollees’ benefits would erode over time. Over the past four decades, we have been fortunate to live in an economic environment where price inflation has been relatively contained. However, due to a series of recent monetary policy mistakes, fiscal policy mistakes and geopolitical events, that is no longer the case. We do not know how long the current period of high inflation will last. Accordingly, without Social Security’s inflation protections, beneficiaries would currently be at great risk of substantial erosion of their living standards.

The COLA is based on a price measure known as the “CPI-W” (Consumer Price Index for Urban Wage Earners and Clerical Workers) averaged during the third quarter of the current year, relative to the third quarter of the previous year. In other words, the calculation determines how much higher, in percentage terms, prices were in July, August and September of this year than they were in July, August and September of 2021. Social Security recipients will get a benefit boost in 2023 equal to that percentage increase.

Put another way, the 2023 COLA attempts to catch beneficiaries up for the price inflation that occurred between late summer 2021 and late summer 2022. Beneficiaries’ purchasing power declined throughout that time, and the 2023 adjustment attempts to make them whole again.

There’s an inevitable lag between when beneficiaries feel the effects of price inflation and when their benefits are adjusted to make up for it. Accordingly, price inflation always creates temporary pain for beneficiaries, even when there is a subsequent COLA.

The COLA Overstates Actual Inflation

The CPI-W that Social Security uses to calculate COLAs is not used because it is the most accurate measure of price inflation. In fact, it is not accurate: It just happened to be the only measure available when Social Security COLAs were established in 1972. There are now many better measures of price inflation. In 1978, the Bureau of Labor Statistics (BLS) added the CPI-U, which is superior because it reflects the purchasing patterns of a much broader sector of the U.S. population, about 87% as opposed to the CPI-W’s 32%.

The BLS achieved a further advance in accuracy in 2002, when it added the “Chained Consumer Price Index for All Urban Consumers” (C-CPI-U). The C-CPI-U is more accurate than either the CPI-U or the CPI-W because it better accounts for changes in buying patterns. In any economy, some prices will go up more than others for various reasons, and other prices may even go down. As a result, what people choose to buy changes over time. The C-CPI-U captures these substitutions in a manner that neither the CPI-U nor the CPI-W does. Because of this, economists generally agree that the C-CPI-U is a more accurate measure of price inflation.

Why doesn’t Social Security use the C-CPI-U to calculate the COLA? The answer is simple: politics. The C-CPI-U tends to be slightly smaller than the CPI-U or the CPI-W, which enables some political activists to misportray this potential correction of the COLA calculation as a “benefit cut.” Of course, the clear intention of the 1972 Social Security amendments wasn’t to compensate beneficiaries in excess of actual price inflation; it was to compensate beneficiaries for price inflation, to the extent it could be calculated. However, where the Social Security Act refers to the “Consumer Price Index” (CPI), it simply references the only CPI that existed at the time the statute was written. Using the C-CPI-U would not be a benefit cut but a closer fulfillment of legislative intent. By contrast, continued use of the CPI-W means compensating beneficiaries in excess of actual inflation.

Perpetuating this mismeasurement of inflation does real damage. It worsens Social Security’s financing shortfall, thereby rendering the other tax increases and/or benefit growth restraints required to maintain program solvency more severe than they would otherwise need to be. Mismeasuring inflation also exacerbates inequities. It redistributes income from shorter-lived Americans to longer-lived Americans, who receive inflated COLAs for more years. Americans who live longer tend to have higher incomes, so this practice worsens income inequality. It also exacerbates the program financing shortfalls that will be inherited by younger generations. Under current law, young workers entering the Social Security system are projected to experience a net income loss through the program of more than 3% of their lifetime taxable earnings, a situation that is exacerbated by calculating COLAs inaccurately.

Some political advocates have actually pushed in the opposite direction from correcting the CPI, arguing that the CPI-W understates inflation as experienced by seniors. Some have called for Social Security to adopt an experimental research measure called the CPI-E, or R-CPI-E, to calculate Social Security COLAs. Using the R-CPI-E would be ill-advised for several reasons. First, it is not a chained index and thus does not capture changes in purchasing patterns that are essential to an accurate measure of inflation.

And even if the R-CPI-E were accurate, it would not be appropriate to use it for Social Security COLAs. Roughly one-third of Social Security beneficiaries are not elderly—they are non-aged disabled individuals, child survivors and so forth. It would be inappropriate to use a measure of inflation developed for one beneficiary subgroup for others to whom it clearly does not apply.

Furthermore, using different CPIs for beneficiaries of different ages would be inherently problematic. The intended purpose of the COLA is to capture not one’s personal inflation rate but national inflation on average. If we were to go down the road toward individually tailored CPIs, there would be little reason to start with discriminating by age when there are many other factors (for example, regional differences in the cost of living) that are potentially much more significant.

Others are concerned that correcting the CPI could increase seniors’ risk of poverty at advanced ages such as 85, 90 and beyond, when many are at risk of outliving their life savings. This is a valid concern, but it is best addressed by a deliberate policy decision in the context of a solvent Social Security system. Such a policy might increase benefits for the longest-lived, most vulnerable seniors, rather than inefficiently applying inaccurate inflation calculations to all benefits at all ages.

U.S. seniors do face different costs, on average, than other Americans do. Seniors tend to spend more on healthcare and less on housing, among other differences. How much federal taxpayer support should be given for retirement income and how much for healthcare coverage are vital policy questions with enormous implications for seniors’ lives. These policy questions, however, are largely separate from the technical question of how to properly calculate price inflation. As we grow older, we have higher health costs for many reasons that have nothing to do with price inflation, much as drivers of older cars have higher maintenance costs. The CPI’s sole job is to measure price inflation, not to address these other important policy questions.

The Net Effect of High Inflation on Social Security Finances Is Unclear

At first glance it may seem obvious that this year’s exceptionally large COLA will be yet another blow to Social Security’s troubled finances. After all, a big COLA means much more money being paid out of the program’s trust funds. Social Security is already in serious financial trouble and can hardly withstand another financial shock. However, the current high-inflation environment may be a mixed bag for Social Security’s finances, and the net short-term effects are far from clear.

Higher inflation means a larger COLA and thus more Social Security spending. However, it also tends to mean a large nominal increase in the Average Wage Index used to compute the maximum amount of worker earnings subject to the Social Security payroll tax. Indeed, we are seeing a large increase in the tax base this year: from $147,000 to $160,200, an increase of nearly 9%. That should bring more tax revenue into Social Security even as its benefit outlays increase.

In addition, the U.S. economy will be exhibiting higher interest rates than it has for a very long time. Higher interest rates also mean more income for the Social Security trust funds, which hold special-issue Treasury securities whose earnings are tied to market rates. So, while Social Security is in deep financial trouble, it’s unclear how much this unusually large COLA will add to it.

The COLA Announcement Should Be a Wake-Up Call for Lawmakers

The most important lesson to be drawn from the latest COLA announcement is that lawmakers need to enact legislation to repair Social Security’s financing shortfall, and do it fast. It is difficult to overstate the severity and urgency of Social Security’s escalating financial crisis. The latest trustees’ report estimates Social Security’s financing shortfall at the equivalent of 24% of future benefit claims. Try to imagine the economic and political repercussions of a 24% across-the-board reduction in every future benefit claimed, starting tomorrow.

Lawmakers would likely never permit such a sudden, dramatic diminution in Social Security benefits. Instead, any changes are likely to be phased in more gradually—perhaps more like 1% in the first year than 24%. But this means in turn that the ultimate changes, when fully phased in, will need to be a lot bigger than even a 24% change in scheduled benefits. The size of the necessary changes grows with further delay.

Lawmakers simply do not have the luxury of putting this off. By the time Social Security’s trust funds are on the verge of depletion in the 2030s, even the complete elimination of all new benefit claims will be insufficient to maintain solvency. If Social Security’s finances are to be saved, federal lawmakers need to act swiftly.

This dire situation doesn’t mean that Social Security is in danger of disappearing. Too many Americans depend on Social Security, and federal lawmakers would surely never permit it. But in the absence of a swift, dramatic change in legislative behavior, it is increasingly likely that Social Security’s historic financing design will be abandoned. To date, Social Security beneficiaries have enjoyed reliability and security in their benefits for one primary reason: the widespread perception that their benefits have been earned and are not considered welfare. That construct is at risk.

The shared belief that Social Security is an earned benefit did not arise by accident. It derives directly from how the program currently works. Social Security is funded primarily by payroll taxes contributed by workers. Those taxes, and interest earnings thereupon, are accounted for in separate trust funds. Individual benefits are based on one’s personal history of taxable earnings, and the program is not permitted to pay more in benefits than its trust fund revenues can finance.

However, there is a price for Social Security’s unique political standing, its earned-benefit construct, and the reliability and security that derive from it. The system only works so long as lawmakers are willing to balance its benefit schedules and its tax revenue. If lawmakers decline to constrain benefit growth rates to the amounts program taxes can finance, then it cannot self-finance. And if Social Security must be bailed out from the general government fund, its historical self-financing basis disappears.

After that point, it would be like just another welfare program, from which many people get benefits for which they didn’t pay, and other people (income tax payers) provide tax revenue without receiving benefits for it. History shows that such welfare programs are subject to constant reassessment of benefit levels and eligibility rules because of the persistent collision of interests between income tax payers and program beneficiaries.

Thus, this year’s exceptionally large Social Security COLA is a reminder of how much its beneficiaries depend on the program and how much they will lose if lawmakers fail to act soon to stabilize its finances. The program won’t be able to deliver such inflation protections in the future unless lawmakers act swiftly to moderate its cost growth and maintain its solvency.

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