How Cost of Living Adjustments are Calculated

When you file for Social Security benefits or Supplemental Security Income (SSI), your lifetime earnings are used to determine the amount of your monthly retirement benefit. However, this number is not static for the rest of your life.

Your social security benefits will increase over time to keep pace with “inflation” or the cost of living. In other words, your retirement benefits will be affected by an annual process, referred to as the cost-of-living adjustment, or COLA.

Congressional legislation authorized cost-of-living adjustments in 1973 and put it into practice in 1975. With these adjustments, SSI and Social Security benefits stay current with inflation to help retirees keep pace with their living expenses. Before 1975, changes to social security benefits were set by legislation.

Impact of COLA on Social Security Benefits

Cost-of-living adjustments are made based on measurements of inflation. When inflationary pressures are present, Social Security benefits adjustments get made in subsequent years. If there are no measurable changes, no COLA is applied.

Because COLA depends on inflation, an increase does not necessarily occur every year. In fact, the Social Security benefits did increase for 2016.

However, beginning with the December 2016 benefit, payable in January 2017, and continuing until the next COLA in October 2017, a COLA increase of 0.3 percent will be reflected in the SSI payments made to Social Security benefit recipients.

As an example, if you received $15,200 in Social Security benefits last year, and this year’s COLA is 0.3 percent, your total benefits for the coming year will be $15,245.60 ($15,200 x 1.003), paid out monthly.

How COLA is Calculated

Cost-of-Living-Adjustments are based upon the Consumer Price Index (CPI), which is the official measurement of inflation used by the U.S government. The Consumer Price Index measures the changes in prices of over 80,000 services and goods.

Cost-of-living adjustments are made based on the CPI as specified by the Social Security Act. Specifically, Social Security adjustments are made using the CPI's Urban Wage Earners and Clerical Workers (CPI-W) measurement. The Bureau of Labor Statistics calculates CPI-W's monthly.

Issues with COLA Calculation Method

There are several concerns with how the Social Security Administration (SSA) estimates the average cost of living adjustments. First, the index the SSA uses only accounts for 32 percent of the total population’s spending habits even though a newer index exists that evaluates 87 percent of people's purchasing habits. Further, this “32 percent” represents a younger “wage earner” demographic rather than seniors or the elderly who are receiving the social security benefits.

Second, the CPI measurement used for determining Social Security benefits adjustments does not take into account shifts in spending habits of consumers when prices change. As an example, increases in the price of gasoline may transition consumers to use mass transit more regularly. The CPI does not reflect that spending shift. As a result, inflation's impact might not be as meaningful, and benefit adjustments might not be required.

Third, there are those who say the current method does not account for costs, such as out-of-pocket health care costs, that affect seniors the most. They feel price indexes should be changed to more accurately measure senior spending.

To date, Congress has not instructed the Social Security Administration to derive a more accurate CPI. In the future, it is possible for Congress to base COLAs on different measurement methods. Since the Social Security Act may be nearing the point of needing a revamp, changing the way to calculate COLA is possible and could be part of any reform package.