A Small 2025 Social Security Cost-of-Living Adjustment (COLA) Could Be Just the Start of the Bad News for Retirees

Retirees collecting Social Security receive an annual cost-of-living adjustment, or COLA, to help them keep up with rising prices. The Social Security Administration calculates the COLA based on inflation data, and it will announce the official number on Oct. 10 this year.

Based on what we know so far, seniors should expect a smaller COLA than they’ve become used to in recent years. In fact, the COLA will likely come in below what analysts expected just a few months ago. The current forecast for the 2025 COLA is a 2.5% increase in benefits. That’s well below the 3.2%, 8.7%, and 5.9% increases retirees saw over the last three years.

But a smaller COLA for next year may be just the start of bad news for retirees, and for anyone planning for Social Security to play an integral part in their retirement budget.

Social Security benefits could be on the chopping block

Social Security has historically brought in more in tax revenue than it’s paid out in benefits. That led to the creation of a trust fund to hold all the excess money until workers retired and claimed their benefits. For a long time, that system worked well.

But over the last few years, the trend reversed. Social Security paid out more in benefits than it collected in tax revenue and earned on its investments. The Social Security Trustees currently expect the Old-Age and Survivors Insurance (OASI) fund to run out of reserve funds sometime in the year 2033.

At that point, Social Security will only be able to pay out as much in retirement benefits as it brings in from taxes. The result is a significant cut in benefits if nothing is done to change the current law or how Social Security operates.

A smaller COLA could lead to bigger cuts

There’s an interesting dynamic between the Social Security COLA and the amount of tax revenue Social Security collects. And the trustees’ report suggests that a lower COLA could actually lead to depletion of the trust fund sooner than anticipated.

In fact, the trustees laid out three scenarios for future COLAs in its most recent report, published in May. Its “high cost” scenario assumed COLAs of 2.5% in 2024 and 1.8% each year thereafter, whereas its “low cost” scenario expected 2.7% for 2024’s COLA and 3% adjustments in future years.

How can it be that paying out less to retirees ultimately ends up costing more? The answer lies in the dynamic between tax revenue and COLA.

As mentioned, the COLA is based on the rise in inflation. Specifically, the Social Security Administration uses the average increase in the Consumer Price Index (CPI) during the third quarter of each year to determine the next year’s COLA. That means the trust pays out benefits based on last year’s data, not this year’s.

Meanwhile, worker wages usually have at least some link to inflation. If inflation is higher, wages tend to move higher, all else being equal. And when wages are higher, Social Security collects more tax revenue. That revenue comes in immediately, but the Social Security Administration doesn’t have to pay out bigger benefits from the COLA until the next year. That gives the Social Security trust more money in the reserves at the start of the next year, and it’s better able to absorb the COLA.

Granted, wages don’t increase in lockstep with the cost of goods. Sometimes the cost of goods will rise faster than wages, but more often than not, wage increases exceed the growth in the CPI. During normal economic times, however, increases in the cost of living have a bigger effect on wages than increases in the standard of living. As such, cost inflation will have the biggest effect on how much tax revenue the Social Security Administration collects in a given year, and on the overall health of the trust fund.

There are certainly other factors that can affect the health of the trust fund, including some that could be caused by very high inflation. All things being equal, though, low inflation (resulting in a smaller COLA) is bad for the long-term viability of Social Security as it stands today. Higher inflation means higher tax revenue for Social Security upfront, which allows it to extend the life of the trust fund’s reserves, even if it has to pay out more next year due to a bigger COLA.

Will the government step in to fix Social Security?

Social Security is the foundation of many seniors’ retirement budgets and many workers’ retirement plans. If things continue as they are, anyone retired or retiring after 2033 will receive just 79% of their scheduled benefits.

Despite lots of talk about potential fixes, Congress has yet to pass any legislation to reform the program and ensure retirees receive the benefits they were promised. And the longer it waits, the harder the challenge.

There are two main proposals for how to fix Social Security.

The first is to increase Social Security taxes on wages. That may be done by increasing the tax rate, or by increasing the amount of income subject to taxation. (Currently, any income above $168,600 in a year is exempt from Social Security tax.)

The other proposal is to raise the full retirement age, which currently sits at age 67. Raising the full retirement age without any other changes to the program is effectively a cut in benefits. Some advocate increasing the year of eligibility (currently age 62), simply shifting back the standard timeline for retirees. That would allow retirees to collect the same amount in benefits if they’re able and willing to wait a little longer to claim Social Security.

Raising taxes today will help stem the short-term shortfall of Social Security, but ultimately it’s not enough to completely offset the long-term trend. Meanwhile, it’s practically impossible to enact an increase in the full retirement age fast enough to overcome the program’s short-term challenges.

Some compromise will be necessary. But given the importance of Social Security to everyone across the political spectrum, there’s reason to remain hopeful Congress will find a solution that helps protect the benefits of America’s seniors.