What the CPI-W Is — and Why It Determines Your Social Security Raise Every Year

Most investors know Social Security benefits are subject to an annual increase, and in most years, that increase is granted.

It begs the question, however: How exactly is this increase determined? Here’s the answer.

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COLAs are meant to offset the rising costs of living

These yearly increases aren’t arbitrary. They aren’t determined by the Social Security Administration either.

Rather, the cost-of-living adjustment (COLA) that regularly raises Social Security benefits is actually based on one of the Bureau of Labor Statistics’ three measures of U.S. consumer inflation. You know them as Consumer Price Indexes (CPIs).

There are actually three Consumer Price Indexes. One of them is the CPI-E, a measure of typical household costs for Americans aged 62 and up.

The one used to determine Social Security‘s yearly COLA, however, is the Consumer Price Index (CPI) for Urban Wage Earners and Clerical Workers, or CPI-W. As the name suggests, this price index measures the average cost of goods and services like housing, transportation, food, and healthcare that every household must purchase. To ensure the social safety net actually does its job, Congress legally requires Social Security to increase its payouts at a pace that keeps up with the official measure of the nation’s overall cost of living.

This isn’t the headline inflation data you hear every month, although it’s usually quite comparable. The number considered the broad barometer of overall inflation is actually the CPI-U, or the Consumer Price Index (CPI) for all Urban Consumers, including working-age households and the elderly, as well as higher-paid professionals and self-employed individuals who aren’t included in the CPI-W calculation. All these figures mostly move in tandem, though.

Nevertheless, as noted, Social Security’s cost-of-living adjustment, put in place at the beginning of each year, is based on the average annualized change in the CPI-W during the third calendar quarter of the previous year. This seemingly premature calculation gives the entitlement program time to make the necessary changes to beneficiaries’ payments.

As it stands right now, next year’s COLA is tracking to be about a 4% increase over this year’s payments. This could still change in the meantime, of course.

An unsustainable model

Criticisms of using CPI-W rather than CPI-E as the basis for Social Security’s COLAs aren’t uncommon. In fact, they’re understandable, primarily because older Americans face measurably higher healthcare costs than working-aged individuals do. Legislation is regularly floated to change this, although none of it has been enacted.

Regardless, the current methodology isn’t entirely unfair or unreasonable, even if it isn’t quite adequate. The bigger concern for retirees right now is arguably the prospect of significant payment cuts — in the ballpark of 22% — if and when the program’s trust fund is depleted, as projected will happen sometime in 2032.

The irony? A key part of the reason Social Security’s trust fund is drying up is specifically that its annual payment increases are only determined by the Bureau of Labor Statistics’ inflation numbers without any consideration of how this trust fund is growing… or not growing. Payouts have clearly grown faster than fresh contributions to this fund have.

Something’s clearly got to change with the model sooner than later.

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What the CPI-W Is — and Why It Determines Your Social Security Raise Every Year was originally published by The Motley Fool