How Inflation Drives Social Security Cost-of-Living (COLA) Movements—and Ways to Plan

The cost-of-living adjustment (COLA) for those on Social Security might be the highest it’s been in more than two decades due to recent inflation. Here’s what you need to know.

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Key Takeaways

  • The Consumer Price Index (CPI) and other inflation metrics have seen a big jump from 2020 to 2022
  • For 2023, the Social Security cost-of-living (COLA) adjustment is now the biggest in 40 years
  • Consider the steps you can take to help prepare for retirement

When inflation jumps, seniors have good reason to be concerned whether their Social Security benefits will go as far as they need. It’s important to understand how benefits may adjust now that inflation was running at 40-year highs by fall 2022.  

Now they have their answer for 2023, and it also represents a 40-year high. Effective January 1, the cost-of-living adjustment (COLA) for Social Security benefits will be 8.7%, the biggest jump since the 1980s. The average Social Security retirement benefit will increase by $146 per month to $1,827 in 2023, up from $1,681 in 2022.

Each year, the government uses the Consumer Price Index for Urban Earners and Clerical Workers (CPI-W) data to calculate whether there will be a COLA for Social Security benefits. Official COLA numbers are generally announced in the fall. In October 2021, the Social Security Administration took already-rising inflation numbers into account in setting its 2022 COLA number at a then-jaw-dropping 5.9%. 

Jaws are no longer dropping—in fact, the adjustment increase announced October 13 was actually smaller than most experts anticipated during summer 2022.

Now the question is how well this increase will serve U.S. retirees as the Federal Reserve and other central banks around the world try to get inflation under control.

How COLAs Work

Social Security announces COLA for the coming year every October based on the latest economic data available. As monthly Consumer Price Index (CPI) readings advanced throughout 2022, experts were split on how high COLA could go. During the summer, some saw the rate going as high as 10%–11%.

So, why did the final 2023 adjustment number of 8.7% land where it did? A big reason was gasoline prices, which hit summer highs and then started to slip by the end of the third quarter. A Medicare policy analyst from The Senior Citizens League—the organization that had correctly predicted the actual number—told Barron’s that the recent gas price slide was reflected in CPI-W.

Here’s what the 2023 adjustment means for seniors.

Cost of living adjustment 2021

Is an Extra $146 Enough?

Many seniors might still be concerned that such a significant increase in 2023 COLA won’t keep up with their expenses, and some could be right based on how they’ve planned their finances.

The COLA is based on a basket of goods and services for the average American, but seniors generally have different spending needs than younger folks.

Prescription drugs are a particular cost concern for seniors who generally face higher health care costs as they grow older. A recent report by the Kaiser Family Foundation found that prices increased faster than inflation for all drugs covered by Medicare in 2020. There is some recent good news here, though.

On August 19, 2022, President Biden signed the Inflation Reduction Act, which requires the federal government to negotiate prices for some drugs covered under Medicare Parts B and D starting in 2026. This new negotiating power expands to more drugs each year, is estimated to save Medicare $98.5 billion through 2031, and is expected to also reduce Part D premiums for seniors.

And starting in 2023, the law requires drug companies to pay rebates to Medicare if prices rise faster than inflation for drugs used by Medicare beneficiaries. And by 2025, the law will cap annual out-of-pocket drug costs for Part D enrollees to $2,000, which could be particularly helpful for seniors with catastrophic health issues like cancer, hepatitis C, or multiple sclerosis.

In addition to reducing Part D premiums, the new Inflation Reduction Act is projected to slow the rise of Medicare Part B premiums too. This is important because Medicare Part B premiums are deducted automatically from Social Security payments, so these premiums reduce spendable income for seniors. Until now, those premiums have increased steadily. In 2022 alone, premiums increased by 14.5%, well ahead of the 2023 COLA increase. To learn more about Medicare and what the different “Parts” cover, visit the government’s website.

What Could Change?

Now that another record-breaking Social Security COLA is set for 2023, some members of Congress want to see a better system for calculating it. Congress introduced legislation that would base future calculations on a CPI that more closely relates to what seniors spend (known as CPI-E); not what the average American worker spends (CPI-W). 

Because the CPI-E adjusts for larger spending for medical and drug costs, the COLA would more accurately reflect where seniors spend their money. But according to the Center for Retirement Research at Boston College, if that measure applied to 2022’s COLA estimate, it might have come in at just 4.8% instead of 5.9% because the country has seen inflationary pressures in so many other categories besides health care. For example, oil and gas prices have contributed an outsize amount to inflation on the CPI-W but are a smaller part of the CPI-E because seniors don’t drive as much as younger folks.

Also remember that higher COLAs can also affect retiree income and potentially affect what many older Americans pay in taxes based on that income. Many retirees who have not previously paid taxes on their benefits in the past could discover they may need to do so in 2023 based on how next year’s COLA number affects their overall finances. In other words, inflation can be in the eye of the beholder, and it’s up to each person—retirees as well as those saving for retirement—to assess their personal situation and decide to what degree Social Security payments might reflect their wants and needs in retirement.

Retirees who have investment savings may see more risk than simple savings. But remember, investing some percentage of savings in the stock market can potentially help mitigate inflation risk. A diversified portfolio may rise faster than inflation over time. Of course, take your time horizon (which may still be 30 years in retirement) and risk tolerance into consideration when creating your diversified portfolio. And keep in mind that all investing involves risk, including the possible loss of principal, even in a diversified portfolio.

If you feel, based on trends and expectations, that you want to rely less on Social Security payments in retirement, you might consider saving more ahead of time if possible or finding other sources of income once in retirement.

Income Streams in Retirement

Many seniors are joining the “gig economy” by driving for a ride-sharing service, renting out extra rooms in their homes, or finding other part-time jobs. With concerns about a labor shortage in the wake of the pandemic, it might be easier for seniors to find supplemental work.

If that doesn’t work for your situation, consider purchasing an annuity* or other investment that offers a constant payment stream. You can even purchase an annuity contract with a guaranteed income benefit that will provide you a COLA each year and/or provide spousal benefits should a spouse die. This outcome is particularly difficult for female spouses who generally live longer, have fewer pension assets and retirement savings, and generally have lower Social Security benefits based on their work record. Ongoing health care and potential long-term care costs should also be a concern.

It’s important for spouses to evaluate their income stream individually instead of simply planning as a couple. 

Part of that evaluation is how COLAs may affect future income and benefits. 

And once again, you’re back to considering the tax impact of any decision you make. For example, will your Social Security be taxed if you keep working once you begin taking it? How will your income from your taxable savings and investments affect your Medicare Part B premiums, which increase at higher income levels? Remember that at age 72, you’ll be required to withdraw from your traditional IRA and 401(k) accounts, and these withdrawals are generally taxable. To mitigate making taxable withdrawals later, for some, it may make sense to investigate converting taxable retirement accounts to a Roth IRA now because the move could allow some seniors to reduce Medicare premiums in their later years. 

If you’re single or married and still planning for retirement, this COLA discussion can be a reminder of the importance of planning ahead. You might even consider a delay in collecting Social Security beyond your full retirement age. Doing so can make you eligible for an additional credit of between 3% and 8%, depending on your birth year.

And women, please make sure you understand what will happen if your spouse/partner dies first. Many male spouses—even with the best intentions—fail to plan for their surviving spouse, which can leave the survivor with financial upheaval during a time of grief and transition.

Make decisions now while you can. No one wants to reach old age and be unprepared.

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Key Takeaways

  • The Consumer Price Index (CPI) and other inflation metrics have seen a big jump from 2020 to 2022
  • For 2023, the Social Security cost-of-living (COLA) adjustment is now the biggest in 40 years
  • Consider the steps you can take to help prepare for retirement

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