The 2% increase represents the cost-of-living adjustment (COLA) for 2018, as determined by the formula used by the Social Security Administration (SSA). This year’s increase is the highest since 2012, but will likely trail broad-based measures of inflation for 2017.
The SSA calculates COLAs by looking at the average of the Consumer Price Index for Urban Wage Earners and Clerical Workers, otherwise referred to as CPI-W, for the three months in the third quarter of the year (July, August and September) and comparing it with the three-month average for the same quarter in the prior year. This calculation is slightly convoluted, so let’s break it down a bit to see what’s actually being measured.
First, the index is important. The name of the index that COLAs are based on—the Consumer Price Index for Urban Wage Earners and Clerical Workers—should indicate that it’s probably not a perfect one to use for retirees. A more common measure, the Consumer Price Index for All Urban Consumers, known as CPI-U, represents about 90% of the U.S. population and is used for most other federal COLAs, like adjusting federal income tax brackets.
Before Social Security recipients get too outraged, it’s important to note that, on average, COLAs have actually outpaced inflation as measured by CPI-W. Since 1999, COLA increases have averaged 2.16% compared to 2.19% for CPI-U, which means COLAs are keeping pace with measured inflation.
The bigger issue is that there’s a large annual tracking error—commonly 1% or more—between COLAs and CPI-U. Over the medium term, Social Security payments have kept pace with inflation, but on an annual basis there’s been a meaningful disconnect in most years.
In addition to CPI-W and CPI-U, the Bureau of Labor Statistics maintains a price index, known as the Consumer Price Index for the Elderly (CPI-E) specifically developed to track the expenses of households containing people 62 years of age or older. Relative to working households, retiree households tend to spend a higher percentage of their consumption on housing and medical care. Periods of high price inflation in housing and medical care can therefore have an exacerbated effect on retirees, since COLAs will not keep pace with actual household price changes.
We believe this is not just a theoretical problem. We believe retirees should expect their overall healthcare costs to increase twice as fast as other expenses. Accordingly, even though Social Security COLAs will likely track economy-wide inflation, most retirees will find that they do not keep pace with their own personal expenditure inflation.
Our long-term inflation estimate is currently 2.4%—a bit higher than market-based inflation expectations. Whether inflation remains near 2% or ends up slightly higher, we don’t see a big risk in quickly accelerating inflation during 2018. Even so, inflation remains one of the core long-term risks retirees have to manage in their investment portfolios.
Read Modern Retirement Monthly, January 2018.