3 Things Retirees Need to Know About How the COLA Is Actually Calculated

Social Security beneficiaries receive a cost-of-living adjustment (COLA) in most years. While this is often referred to as a raise, it's actually an adjustment to help retirees avoid losing their buying power to inflation.

Seniors need to understand the truth about the COLA and about what it can do for their finances. In particular, here are three things to know about how it's calculated.

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1. The Social Security COLA is based on third-quarter inflation data

The first thing to know is that the COLA is calculated using third-quarter data from the Bureau of Labor Statistics. Specifically, the Social Security COLA is based on the percentage increase in the average Consumer Price Index for Urban Wage Earners and Clerical Workers, or CPI-W, for the third quarter (July through September) compared with the average CPI-W for the same quarter of the prior year.

When the CPI-W data comes in, the Social Security Administration announces the COLA -- usually in October each year, since the key months are July, August, and September. That can be a problem, though, because inflation can change.

If the third-quarter CPI-W numbers show the cost of living is up 3%, benefits will increase by 3%. But inflation could surge in October, November, and December after the COLA has already been calculated. No adjustment would be made to Social Security because inflation got worse after the increase, and if high levels of inflation persisted throughout 2027, retirees might really struggle.

2. It may not be the most accurate measure of senior spending

The second thing to know is that CPI-W may not actually be the most accurate approach to determining how much to increase benefits. After all, the spending habits of seniors are not perfectly aligned with those of urban wage earners and clerical workers. As a result, the COLA formula typically underestimates how much seniors spend on certain things, such as healthcare costs.

Unfortunately, COLAs often end up making adjustments that are too small, since the areas where seniors tend to spend a lot, such as on medical care, tend to see more rapid price increases. The Senior Citizens League estimates that retirees lost around 20% of their buying power between 2010 and 2024 because of this issue.

This knowledge is important in your retirement planning, as you need to be aware that your Social Security won't stretch as far later in retirement once inflation has eaten away at its purchasing power. You need to ensure you save enough in retirement plans to supplement your benefits.

3. You aren't guaranteed a COLA, but benefits can't go down

Finally, the last thing to know is that you aren't guaranteed an annual adjustment to your benefits. If the inflation data shows that prices stayed the same or that they declined, your benefit will not change. The good news is, though, that if deflation is happening and prices start to go down, you won't lose any benefits.

There have been several years in which seniors did not get a Social Security adjustment, including 2010, 2011, and 2016. While inflation is high right now and this outcome isn't likely anytime soon, it's possible it could happen again in the future, so retirees need to be prepared.

The reality is, while you may assume it's a bad thing not to get a benefit adjustment or to just get a small one, many retirees benefit from lower inflation. So if there's a year when a COLA doesn't come, as long as inflation stays low throughout that year, retirees could end up better off, as their retirement plans (that don't usually have automatic inflation protections) won't end up losing buying power because of rising prices.

Retirees should watch for news of the COLA in October so they can see how their income will change next year. Just don't expect that the adjustment will give you too much more buying power, since it's not really a raise but rather intended to help your benefits hold their value during times when prices rise.

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