Alternative Inflation Measures for the Social Security Cost-of-Living Adjustment (COLA)
Released: 2015-10-15T00:00:00

Social Security COLAs Under Current Law

Monthly Social Security payments for retired workers, disabled workers, and all other beneficiaries are generally increased annually by a cost-of-living adjustment (COLA) that is based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The COLA applies beginning with the second year that a person is eligible to receive benefits. The first-year benefit is based on a formula that is linked to overall wage growth. Under current law, the COLA equals the percentage increase in the average CPI-W from the third quarter of the base year (the last year for which a COLA was applied) to the third quarter of the current year. The Bureau of Labor Statistics (BLS) generally releases the September CPI-W by mid-October, and the Social Security Administration (SSA) then computes and announces the COLA. The COLA becomes effective in December of the current year and is payable in January of the following year. Social Security payments always reflect the benefits due for the preceding month. For example, the payment that a beneficiary received in January 2015 reflected the benefit for December 2014.

Since 1975, a COLA has been paid in every year except 2010 and 2011. Because the average inflation as measured by the CPI-W for the third quarter of 2015 as compared with 2014 was negative (-0.4%), the SSA has announced there will be no COLA for 2016. A COLA of 1.7% was payable in January 2015.

The CPI-W and Alternative Measures of Inflation

Inflation is generally measured by computing the increase in the cost of the goods that an average person purchases. The CPI-W is an estimate of the average change in prices of the goods and services purchased by households whose income comes primarily from a clerical or wage occupation. In general, BLS measures the price change of each item in the "basket" of goods, and then computes overall inflation, weighting each of those price changes by the item's share of spending.

The consumer price index for all urban consumers (CPI-U) is more broadly used than the CPI-W. BLS uses the same price data and methodology to compute the CPI-W and the CPI-U, but the CPI-U is based on the expenditures of about 87% of the population, whereas the CPI-W reflects expenditures of about 32% of the population. BLS introduced the CPI-U in 1978 and renamed the existing inflation measure the CPI-W. The CPI-W continues to be used for the Social Security COLA even though it measures the inflation facing a population—urban wage earners and clerical workers—that by definition are employed, unlike most Social Security beneficiaries. However, the two measures tend to track each other closely.

Criticisms of Basing the Social Security COLA on the CPI-W

General Criticisms

Some shortcomings of the CPI are inherent in any price measure. For example, the CPI is based on an average of all consumption in the nation, whereas actual purchases and prices paid vary by individual. Therefore, virtually everyone will experience inflation that is either higher or lower than the measured rate.

Other shortcomings are technical and can be addressed by changes in methodology. In recent years, BLS has adjusted its processes to reduce an upward bias in the CPI. For example, they have improved the adjustments they make to the index to account for the introduction of new products and changes in the quality of existing products.

They have also incorporated procedures that partially account for the "substitution effect"—the fact that consumers cushion themselves from the effect of relative price increases by adjusting their purchasing patterns, and they take advantage of relative price decreases. For example, if the price of apples grows much faster than the price of pears, people often buy more pears. Conversely, if apples go on sale and pears do not, sales of apples would increase. A price increase still reduces consumers' standards of living, but the reduction is smaller than it would be if they were forced to buy the same items every month.

The CPI-W Overstates Overall Inflation

BLS has identified two factors that cause the CPI-W (and the CPI-U, which uses the same methodology) to overstate inflation. First, the CPI-W does not fully account for substitution. The BLS calculates price indexes for 211 categories of goods in 87 geographic areas. The CPI-W adjusts for the effects of substitution within those "item-area" categories, but not between them. Second, a "small-sample" bias arises because BLS can collect only a sample of the numerous prices in the economy. This bias is separate from the uncertainty that arises whenever an estimate is based on a limited sample; the small-sample bias causes inflation to be systematically overstated.

The CPI-W May Understate Inflation Experienced by Older People

In contrast, some analysts point out that the CPI-W may understate the average inflation experienced by Social Security beneficiaries because older Americans consume a greater than average share of goods whose prices tend to rise more rapidly than average, most importantly health care and housing. The CPI-W tracks the spending habits of urban wage and clerical workers, but about 80% of Social Security beneficiaries are aged 62 or older and therefore tend to have different spending patterns. Persons aged 62 and older spend around twice as much of their direct outlays on health care as does the rest of the population, a difference that accounts for about half of the difference in the growth rates of the CPI-W and the Experimental Consumer Price Index for Americans Aged 62 and Older (CPI-E), a price index for the elderly. Older Americans also spend more than average on other goods whose prices usually rise faster than average, such as housing.

The Chained CPI-U

In August 2002, BLS introduced a supplemental index, the Chained CPI for All Urban Consumers (C-CPI-U). Although the series was first published in 2002, BLS has produced monthly values for the index beginning in December 1999.

Unlike the CPI-W (and the traditional CPI-U), the C-CPI-U fully accounts for substitution by consumers and effectively eliminates small-sample bias. The weights used for the traditional versions of the CPI are updated every two years to reflect changes in spending patterns. It therefore does not fully incorporate the monthly effects of changing prices on spending patterns. In contrast, when BLS estimates the C-CPI-U, it estimates weights for each month separately, thus "chaining" the two months.

The C-CPI-U tends to increase at a slower rate than the CPI-W. The Social Security Administration's Office of the Chief Actuary estimates that the C-CPI-U will grow an average of 0.3 percentage points more slowly than the CPI-W, which is equal to the average differential since 1999. The Congressional Budget Office (CBO) estimates that the differential will average 0.25 percentage points, slightly lower than the historical average, because it excludes some data from the early 2000s, before BLS made some methodological changes.

Revisions to the C-CPI-U Would Complicate COLA Computations

Because data on actual spending patterns are collected every two years, the initial release of the C-CPI-U—which occurs several weeks after the end of the month for which inflation is being measured—is based on estimated spending patterns. Interim estimates are released in February of the next year. The final release, which is based entirely on actual spending data, is released the following February, as much as two years after price data are collected.

The lag between the initial and final releases of the C-CPI-U would complicate COLA calculations. SSA announces next year's COLA in mid-October, soon after BLS releases the current year's September CPI-W figure, as described above. To address the issue of the long time lag between initial and final releases of the C-CPI-U for a given month, some have proposed basing the Social Security COLA on the initial release of the C-CPI-U (the initial C-CPI-U is published at the same time as the CPI-U and the CPI-W, i.e., just a few weeks after the end of the month for which price changes are being measured). The difference between the initial and final releases could be reflected in COLAs for subsequent years.

Would a C-CPI-U Overstate Older Americans' Ability to Substitute Among Consumer Items?

Some argue that the low-income elderly have less ability than the average consumer to change what they buy when prices change because they spend most of their income on essential items, such as housing, food, health care, and utilities. These essential items are not good substitutes for each other. For example, if the price of electricity rises, some low-income elderly might not be in a position to reduce electricity purchases, particularly if they are already purchasing little electricity.

If it is true that some low-income elderly have less ability to substitute among items in response to relative price changes than other consumers, then the C-CPI-U would not capture the full impact of relative price changes on the low-income elderly. That is, the C-CPI-U would underestimate the impact of inflation facing the low-income elderly. However, there is little research on this question.

The Experimental CPI for the Elderly

In response to concerns about how effectively the CPI-W tracks the spending patterns of older consumers, in 1987 Congress directed BLS to introduce an index for the elderly. BLS developed the CPI-E and constructed values for the series for 1982 and later. However, a fully developed price index for the elderly might differ from the CPI-E, which is computed using price data from the same geographic areas and retail outlets as the CPI-W and CPI-U; only the consumption weights differ. BLS commissioner Erica Groshen testified, "We recognize that elderly households live in different places, shop at different retail outlets, buy a different mix of products, and even in many cases qualify for different prices than other urban consumers."

The experimental CPI-E index also may not be appropriate for Social Security COLAs because the over-62 population differs from the population of Social Security beneficiaries. Many Social Security beneficiaries are under the age of 62, such as surviving children and most disabled workers. And some people over 62 are not Social Security beneficiaries, such as the substantial portion of persons aged 62 to 64 who have not yet claimed benefits.

On average, the CPI-E has increased by an average of about 0.2 percentage points faster than the CPI-W or CPI-U since 1982. SSA's Office of the Chief Actuary expects the differential to remain at that level.

Several bills to set Social Security COLAs equal to growth in a CPI for the elderly have been introduced in the 114 th Congress, such as H.R. 1391 , H.R. 1811 , H.R. 1984 , H.R. 3351 , H.R. 3588 , S. 731 , S. 960 , S. 1904 , S. 1940 .

Effects of Changes to the Social Security COLA: Policy Considerations

This section discusses issues that may inform the debate about whether to base the Social Security COLA on either the C-CPI-U or the CPI-E instead of the CPI-W. It first discusses how the cumulative impact of such a change would grow as individuals aged and how Social Security becomes an increasingly important source of income for older beneficiaries. It then discusses the projected impact on Social Security's overall finances of a change in the COLA.

Effect of Changes on Different Groups of Beneficiaries

The effect of higher or lower COLAs would be cumulative; that is, the impact on benefits would grow with each additional year of benefit receipt. Benefits for people who had just become entitled, such as 62-year-old retired workers or newly disabled workers, would be unaffected, because first-year benefits are not affected by COLAs. The changes would always be small for people who had only been entitled to benefits for a few years, and they would be small for all beneficiaries in the first few years after a policy change, because those groups would have been subjected to the higher or lower COLAs for only a short time. The changes would be largest for people who received COLAs under the new policy for many years, such as the very old or people who had been disabled for a long period.

For example, if the COLA was based on the C-CPI-U and it grew 0.3 percentage points more slowly than the CPI-W, as projected by the SSA, then the benefits of 65-year-olds—who will have experienced three years of COLAs—would be reduced by 0.9% (see Figure 1 ). The reduction would increase as the worker aged: to 3.7% at age 75 and 6.5% at 85. That is, beginning 23 years after the policy was changed, scheduled monthly benefit payments for 85-year-old beneficiaries would be 6.5% lower than they would be under current law.

And if, for example, the CPI-E or a similar measure were used to compute the COLA and it grew 0.2 percentage points faster than the CPI-W, as projected by the SSA, then benefits would be 0.6% higher for retirees at age 65, 2.6% higher at 75, and 4.6% higher at 85.

Although the cumulative effect of a change in the COLA is largest for people who have been subject to the change for many years, the number of people affected declines with age as people die. For example, only about half of 62-year-olds live to age 84 (see Figure 1 ).

Because benefit changes cumulate, the effect of a change in COLAs on lifetime benefits would depend on how long a retiree lives. On average, people who had higher earnings over their lifetime live longer, so they would be most affected.

However, older beneficiaries tend to have lower current income and to depend more on their Social Security benefits than younger groups. At advanced ages, most beneficiaries are no longer able to work, and many beneficiaries who had savings at retirement have depleted those savings. For the minority of the elderly with defined benefit pensions, the purchasing power of those payments generally declines over time because it is not usually indexed to inflation. As a result, poverty rates increase with age. Among beneficiaries aged 65 to 69, 5.7% were poor in 2012; the poverty rate for those 80 or older was 9.2%.

As shown in Figure 2 , older beneficiaries depend more on their Social Security benefits than do younger ones. For example, for more than half of those aged 80 and older (54%), Social Security benefits are at least 80% of total income. In contrast, for only 29% of the 65-69 age group do Social Security benefits represent at least 80% of total income.

Changing how the COLA is computed is one of the few recent Social Security proposals that would affect current beneficiaries. Many options to reduce Social Security benefits would change the way benefits are calculated for new beneficiaries, and many proposals would reduce benefits only for people currently aged 55 or younger.

Effect of Changes on Social Security's Financial Status

One measure of Social Security's long-term financial status is the system's annual income and cost rates. Under current law, the Social Security cost rate—spending as a share of taxable payroll—is projected to grow from about 14% today to around 17% in 2035 and later. (Taxable payroll is all earnings subject to the Social Security payroll tax.) The income rate, which is all tax revenue as a share of taxable payroll—is projected to remain around its current level of 13%.

If the COLA were based on the C-CPI-U beginning in 2016, the Social Security actuary projects that future Social Security benefits that are based on current law would ultimately decline by about 4%, or 0.7% of taxable payroll (see Figure 3 ). Switching to the CPI-E would ultimately increase spending by about 3%, or 0.5% of taxable payroll.

A second measure of Social Security's long-term financial status is the system's summarized income and cost rates. The Social Security trustees project the 75-year summarized cost rate to be 16.77% of taxable payroll and the summarized income rate to be 13.89%, resulting in a deficit of 2.88%. Basing the COLA on the C-CPI-U beginning in 2015 would reduce the deficit by 0.56% of taxable payroll, according to the Social Security actuaries (see Table 1 ). Using the CPI-E beginning in 2016 would increase the deficit by 0.38%, according to the Social Security actuaries.

Setting the COLA equal to the C-CPI-U for benefits paid in 2016 and later would reduce spending by $116 billion from FY2016 through FY2024, according to CBO. (CBO assumes that the C-CPI-U will grow 0.25 percentage points slower than the CPI-W.) Budget estimates for using the CPI-E are not available, but under the assumption that the CPI-E will grow 0.2 percentage points faster than the CPI-W, basing the COLA on it would increase Social Security outlays by about $93 billion over the same period ($116 billion x (0.2/0.25)=$93 billion).

Proposals to Base the Social Security COLA on the C-CPI-U and Partially Offset the Resulting Benefit Reductions

The President's 2014 budget proposed basing the Social Security COLA on the C-CPI-U, but it would also shelter older beneficiaries from the full effect of that change. That proposal was not included in either of the two subsequent proposed budgets. In 2010, similar proposals were made by the National Commission on Fiscal Responsibility and Reform (chaired by former Senator Alan Simpson and Erskine Bowles, hereinafter the "Fiscal Commission") and the Bipartisan Policy Center (chaired by former Senator Pete Domenici and Alice Rivlin).

Offsets Proposed in the President's 2014 Budget

The President's 2014 Budget proposal included a separate provision that would in isolation increase benefits for older beneficiaries. The increase would begin at the age of 76 for retired workers and in the 15 th year of benefit eligibility for disabled workers. The increase would be phased in over 10 years, so it would increase benefits for 85-year-olds by 5% of the average retiree benefit. Because everyone would have the same increase, benefits would increase by more than 5% for people with lower benefits and by less for those with higher benefits. A second benefit increase would apply beginning at the age of 95, although that would affect relatively few people; less than 10% of people aged 62 live until 95. On net, people with the lowest benefits would experience a slight increase in benefits at some ages, because that provision would more than offset the expected effects of the lower COLA.

Offsets in Other Proposals

The Fiscal Commission proposed a similar measure; their "20-year benefit bump up" would increase benefits by 5% of the national average benefit for persons who have been eligible for benefits for 20 years (eligibility is defined as a determination of disability, or the earliest eligibility age for retirement benefits, which would rise gradually from the age of 62 to 64 under the commission's proposal). The enhancement would be phased in over the five years from the 20 th through 24 th years after eligibility, in increments of 1% per year. The total 5% increase would continue to apply in all subsequent years of benefit receipt. Both the Fiscal Commission and the Bipartisan Policy Center also include measures that would increase initial benefits for people with lower lifetime earnings.

Other Options for COLA Changes

COLAs need not be linked directly to any measure of inflation. Another option would be to have COLAs be greater than inflation, for example by linking them to wage growth, which is on average higher than price inflation. Currently, initial retirement benefits, which workers can claim beginning at age 62, are linked to wage growth through the age of 60. Because COLAs are linked to prices, retirees do not share in any of the increase in the purchasing power of wages that occurs after they are 60 years old. In isolation, such a change would increase Social Security spending, which would ultimately have to be offset either by an increase in taxes or a reduction in initial benefits.

Under current law, all beneficiaries receive the same COLA (i.e., the percentage increase), but some proposals would means-test COLAs. People with more income or higher benefit levels would receive a lower COLA than people with lower income or benefits.

Other Federal Provisions Affected by the Social Security COLA Computation

Other Social Security Provisions Affected by the Social Security COLA Computation

The Social Security COLA affects other provisions of the Social Security program. By law, if there is no change over the relevant measuring period in the CPI-W, and consequently no COLA, there can be no change in the following program parameters:

The taxable wage base, which is the amount of covered wages subject to the Social Security payroll tax. The taxable wage base is $118,500 in 2015. Exempt wage and salary amounts under the retirement earnings test, which reduces the monthly benefit of Social Security beneficiaries who are below the full retirement age and have earnings that exceed an annual threshold. The exempt amounts are $15,720 for workers under full retirement age in 2015 and $41,880 for workers who reach their full retirement age in 2015. Substantial gainful activity (SGA) amounts for blind individuals who receive Social Security disability benefits. The threshold for these individuals is $1,820 in 2015. (The SGA amount for nonblind individuals may increase even when there is no COLA.)

These program elements are adjusted annually based on the increase in the national average wage index only if there is a COLA. As a result, these program elements remained at their 2009 levels in 2010 and 2011, but they were adjusted upwards in subsequent years, when COLAs were paid. Likewise, these program elements will remain at their 2015 levels in January 2016.

Other Programs Affected by the Social Security COLA Computation

Beneficiaries of other programs are also affected by the absence of a Social Security COLA, including low-income elderly and disabled persons, veterans, and federal civil service annuitants. As a result, beneficiaries of the programs listed below did not receive COLAs in January 2010 and January 2011 and will not receive a COLA in 2016.

The Social Security COLA triggers an increase in benefits paid under

Supplemental Security Income (SSI), Veterans' Pension Benefit Programs, and Railroad Retirement Board (RRB) Programs.

The absence of a COLA increase may impact certain Medicare Part B enrollees. Most Medicare Part B enrollees have their Part B premiums withheld from their monthly Social Security benefits. For these individuals, a hold-harmless provision in the Social Security Act (§1839(f)) ensures that their benefits will not decrease as a result of an increase in the Part B premium. In most years, the hold-harmless provision has little impact; however, in a year in which there is a 0% Social Security COLA and a Part B premium increase, such as happened in 2010 and 2011, the hold-harmless provision may apply to a much larger number of people. As a result of a 0% Social Security COLA in 2016, an estimated 70% of Medicare beneficiaries would be protected by this provision in the event of an increase in the Part B premium, and their 2016 premiums would be the same as in 2015. However, about 30% of beneficiaries are not protected by this provision. This includes higher-income enrollees, new Medicare Part B enrollees, individuals who do not receive Social Security benefits, and low-income enrollees whose premiums are paid by Medicaid. To ensure that the Part B program has sufficient income from premiums and general revenue contributions, the premiums paid by those not held harmless may be significantly higher than if the hold harmless provision were not in effect.

COLAs under the following programs are not triggered by the Social Security COLA, but they use the same measurement period and formula for computing COLAs as the Social Security program:

Civil Service Retirement System (CSRS) and Military Retirement System.

The Federal Employees Retirement System (FERS) uses the same measurement period for computing its COLA as the Social Security program, although a modified formula is used to limit the COLA.

Benefits paid to disabled veterans and to survivors of certain service members and veterans under the following programs are not automatically indexed for inflation. However, Congress enacts legislation each year to provide a COLA equal to the Social Security COLA for

Veterans' Disability Compensation and Dependency and Indemnity Compensation (DIC) for Survivors.