Currently, the COLA is set by averaging inflation for the third quarter, as reflected by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).
No COLA was awarded in 2010 or 2011 due to a quirky inflation spike in the third quarter of 2008, due mainly to a sharp rise in energy prices; that resulted in a whopping 5.8% COLA for 2009. By law subsequent Social Security payments couldn't rise until the CPI-W exceeded the 2008 level.
This year, the third quarter CPI-W averaged 3.6%
--again, due to higher energy costs
, and food. (The chart below illustrates the dip and subsequent bounce-back of consumer prices over this period.)
But the COLA news also comes against a backdrop of debate about what inflation measure should be used to determine annual benefit adjustments. Many advocates for seniors and Social Security have argued for years that the CPI-W understates the inflation that impacts seniors--mainly health-care expenses. They've been pushing for adoption of a more generous measure that better reflects seniors' costs, called the CPI-E (for elderly).
The CPI-E aims to reflect the spending patterns of people over age 62, mainly health care. Used instead of the CPI-W, it would translate into monthly benefits about 6% higher for a retiree at age 92, according to the National Academy of Social Insurance (NASI).
But the key federal deficit reduction plans that have been advanced in Washington move in the opposite direction. These plans have recommended adopting a measure of inflation called the "chained CPI." A chained index reflects changes that consumers make in their purchasing across dissimilar items in response to price changes; the theory is that a spike in gasoline prices might, for example, prompt consumers to spend less on fuel and perhaps more on food.
Two deficit reduction commissions have advocated applying the chained CPI to federal benefit programs and to the income tax code--President Obama's National Commission on Fiscal Responsibility and Reform
and the Bipartisan Policy Center's Domenici-Rivlin plan
. It's one of the ideas being considered by the Congressional Super Committee on deficit reduction.
On the benefit side, a chained CPI would impact Social Security, civilian and military pensions and veterans' benefits, and Supplemental Security Income. On the revenue side, a chained CPI would be applied to inflation adjustments for tax brackets in the personal income tax code, effectively serving as a stealth tax hike by reducing tax bracket adjustments and subjecting more of individuals' earnings to higher tax rates over time.
According to the Congressional Budget Office, benefit adjustments could yield $217 billion over 10 years, with 52% of that--$112 billion--coming from reduced Social Security COLAs; income tax bracket creep would generate $72 billion.
If we do chain the CPI, it's going to be controversial. While most proposals to cut Social Security benefits push the changes far down the road, this change would begin impacting seniors almost immediately.
And while the Social Security Administration projects that the chained CPI will rise only about 0.3 percentage points less per year than the CPI-W, don't forget that this compounds over time for beneficiaries. NASI estimates show it translates to a monthly benefit cut of 8.4% for a retiree at age 92 (calculated from age 62, the first year of eligibility).
Seems like that certainly would take some of the fizz out of the COLA.
Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com