Note from dshort : I've updated this commentary to include the 2014 Social Security COLA announced this week to take effect in December.
Each year the Social Security cost-of-living adjustment COLA is calculated based on the change from the Q3 average of the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) from the Q3 average of the previous year, rounded to one decimal place. If the average for the most recent year is below the previous high, there is no adjustment, as was the case in 2010 and 2011. Note that for 2011, the Q3 average was indeed higher than the 2010 average, but it was still below the 2009 average, hence no COLA. For the official announcement of the calculation on Social Security website, click here.
The President's 2014 proposed budget recommends that, starting in 2015, COLAs should be calculated with the Chained Consumer Price Index for All Urban Consumers (C-CPI-U). Let's look at what the effect would have been over the past twelve years for a typical Social Security recipient.
The earliest Q3 of Chained CPI data we have is for the year 2000. So the first COLA we can calculate would be for 2002 based on the change from Q3 2000 to Q3 2001. Here is a table showing the actual COLAs since 2002 and the hypothetical COLAs if we substitute the Chained CPI. I've illustrated the difference with a case history of a Social Security recipient who had received $12,000 in 2001, an even thousand per month, which I think was fairly close to the national average in that year. The rightmost column shows the annual and total shrinkage of annual income had the Chained CPI been used for COLA calculations.
When we compare the official COLA with the Chained CPI COLA in 2014 for our hypothetical retiree in the 13th year of retirement, the annual payout would be 3.4% less than with the traditional COLA calculation. In our illustration above, that's about $46 less per month, which would buy a fair amount of groceries for a frugal shopper at Wal-Mart.
The Social Security COLA calculation involves rounding to one decimal place. Note that for 2014, the rounding gives us the first time in this 13-year data series (aside from the two years of no COLA) that the Chained CPI calculation would have been the same official CPI-W COLA.
As the table illustrates, over time the proposed switch to the Chained CPI for Social Security COLAs will substantially lower the cost to government … and the size of payouts to recipients.
for a more detailed analysis of Chained CPI, see this commentary:
Note : The BLS explains that "The C-CPI-U is issued first in preliminary form, and subject to two subsequent revisions. These revisions have been relatively small, and are expected to be small in the future. Revisions to 12-month changes in the All Items index, for example, generally have been 0.2 index points or less."
The latest Chained CPI spreadsheet from the BLS shows the monthly data points for 2013 as Initial. All data points for 2012 are labeled as Interim. It's unclear how a future use of Chained CPI for Social Security COLAs would handle adjustments in the index calculations.