Motley Fool
0
All posts from Motley Fool
Motley Fool in Motley Fool,

How Social Security's 2018 COLA Is Calculated

As of September, nearly 62 million people were receiving a monthly check from Social Security, including 42.2 million who are retired workers. More than 60% of these retirees rely on their monthly stipend from the Social Security Administration (SSA) for at least half of their income. You could rightly say that without Social Security, these seniors would be in big trouble, financially.

For all beneficiaries, and especially seniors, no time of the year is more important than mid-October. This is when the SSA announces its multiple Social Security changes for the upcoming year. This often includes adjustments to the maximum monthly payout at full retirement age, inflationary adjustments tied to the earnings test, and, of course, the announcement regarding Social Security's cost-of-living adjustment, or COLA. COLA is a term that describes what, if any, raise Social Security recipients will receive in the coming year. 

Image source: Getty Images.

On Oct. 13, 2017, it was announced that Social Security beneficiaries will receive a 2% COLA in 2018, marking the highest "raise" over the past six years. Many retirees, though, may not see much of a bump in their check as a result of Medicare Part B premiums eating up their COLA next year.

But you might be wondering how the SSA determines what sort of raise its beneficiaries should get from one year to the next. Let's take a closer look.

How does Social Security measure inflation?

The way the SSA tethers Social Security benefits to inflation is by linking payouts to the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The CPI-W has eight major spending categories that cover various goods and services. As listed by the Bureau of Labor Statistics, which reports CPI-W data on a monthly basis, these categories are:

  • Food and beverages
  • Housing
  • Apparel
  • Transportation
  • Medical care
  • Recreation
  • Education and communication
  • Other goods and services

Image source: Getty Images.

While many of these categories are pretty straightforward, a few may not be. For instance, "other goods and services" encompasses personal services such as haircuts, along with certain discretionary items such as tobacco and smoking products. In a few rare instances you may also find an expense that you'd expect to be in one category in another. For example, fuel oil, which is used as a heating source in homes, is a component of the housing category and not lumped in with gasoline in the transportation category.

How does the SSA make sense of the CPI-W data?

Despite monthly CPI-W data, the SSA doesn't factor in anywhere near this amount of data when determining Social Security's annual COLA. Instead, the SSA uses the average CPI-W reading from the third-quarter of the previous year (July through September) as its baseline figure and the average reading from the third quarter of the current year as the comparison. Readings from the first, second, and fourth quarters simply don't factor into Social Security's COLA calculation.

If the average third-quarter CPI-W reading from the current year is higher than last year, then the difference in percentage terms, rounded to the nearest 0.1%, is what beneficiaries can expect as a raise in the upcoming year.

As an example, here are the 2016 third-quarter CPI-W readings:

  • July (234.771)
  • August (234.904)
  • September (234.495)

The average reading across the third quarter of the previous year was 235.056, which serves as the baseline.

Image source: Getty Images.

Now, here are the CPI-W readings from the third quarter of 2017:

  • July (238.617)
  • August (239.448)
  • September (240.939)

The average reading here is 239.668, representing 1.96% year-over-year growth from the third quarter of 2016. When rounded to the nearest 0.1%, we're looking at a 2% raise for beneficiaries in 2018. 

If the prices for goods and services falls year over year, Social Security benefits remain static. Thankfully they can never fall as a result of deflation. Beneficiaries have received no COLA in three of the past eight years as a result of the CPI-W falling in the third quarter from the previous year.

What's really responsible for the biggest raise in six years?

Now that you have a much better idea of how Social Security's COLA is calculated, you're probably wondering what factors were specifically behind 2018's 2% COLA. Amazingly, it really comes down to just two factors.

Image source: Getty Images.

The first are energy prices, which soared in August and September as a result of refinery shutdowns and drilling moratoriums caused by hurricanes Harvey and Irma. Gasoline prices for the CPI-U (Consumer Price Index for All Urban Workers, a similar measure to the CPI-W) rose by 6.3% in August an 13.1% in September from the previous year, with fuel oil also rising significantly in August (2.9%) and September (8.2%). While hurricanes aren't a good thing, they can result in a timely inflationary bump for Social Security beneficiaries on occasion.

Housing costs were the other factor, with observed CPI-U price-change readings of 0.1%, 0.5%, and 0.3%, respectively, in July through September. Again, while the CPI-U and CPI-W aren't identical, you can get a pretty decent feel using the CPI-U of what spending categories had the most influence on Social Security's COLA. Since housing tends to be the single most costly expenditure for most folks, it holds a lot of weighting in the CPI-W. On an unadjusted 12-month basis through September, shelter costs had risen 3.2%, which was a full percentage point higher than the CPI-U had risen across all categories over the past year. 

Because there are so many variables involved with the CPI-W, there's simply no way to know in advance what sort of COLA beneficiaries could be looking at in an upcoming year.

Does the CPI-W accurately measure the inflation seniors face?

Finally, since 68% of Social Security's recipients are seniors (the rest are survivors, the disabled, and families of eligible beneficiaries), you might be wondering if the CPI-W accurately represents the inflation that seniors face. The unfortunate answer here is "no."

Image source: Getty Images.

The CPI-W focuses on the spending habits of urban working-age Americans and clerical workers. These working adults tend to spend more of their income on education, apparel, transportation, and food and beverages than seniors. Comparatively, seniors will spend more of their money on medical care and housing relative to working-age Americans.

The result is that in spite of raises being given to beneficiaries, many seniors have seen their purchasing power erode over time. Medical care inflation have outpaced Social Security's COLA in 33 of the past 35 years (not counting 2017), and housing inflation has topped Social Security's COLA in a number of recent years, too.

One possible solution being thrown around Capitol Hill involves switching to a new inflationary tether known as the Consumer Price Index for the Elderly. As the name suggests, it would only factor in the expenditures of households with persons ages 62 and older. While this would likely result in a truer COLA for seniors, it'd still fail to take into account Medicare Part A expenses (also known as hospital insurance), and it would more quickly drain Social Security's coffers, which are already facing a $12.5 trillion budget shortfall between 2034 and 2091.

In short, don't expect Social Security's inflationary tether to change from the CPI-W anytime soon.

The $16,122 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.

The Motley Fool has a disclosure policy.