The Importance of the Social Security Cost of Living Adjustment

Dean Baker, a co-director of the Center for Economic and Policy Research, released the following statement today on the Social Security Cost of Living Adjustment (COLA):

"The Social Security Administration announced today the annual cost of living adjustment (COLA) for 2013 benefits will be 1.7 percent. This means that people who are currently receiving Social Security benefits will see their checks increase by 1.7 percent beginning in January.

"Since 1975, Social Security recipients have seen their benefits increase in accordance with the cost of living, based on the Labor Department's Consumer Price Index (CPI), which measures monthly changes in prices for a representative basket of goods and services. The point of indexing benefits to the cost of living is to ensure that the real value of the benefits of retirees, disabled workers, survivors and their families does not decline through time.

"This history is worth noting because many in Washington are arguing for a reduction in the annual COLA. Instead of continuing to use the CPI for Urban Wage Earners and Clerical Workers (CPI-W ), the current index for setting the annual cost of living adjustment, they want to switch to a new index, the Chained CPI for All Urban Consumers (C-CPI-U).

"Unlike the CPI-W, which holds the basket of goods fixed through time, the C-CPI-U measures the price of a basket of goods that changes in response to the relative price shifts of various goods. For example, if a rise in the price of beef leads people to buy more chicken, then the C-CPI-U would have a higher weight on its chicken component and a lower weight for its beef component.

"The Bureau of Labor Statistics (BLS) has been calculating the C-CPI-U monthly since 2002. On average it has shown a rate of inflation that is 0.3 percentage points less than the current index. If it were adopted as the basis for the indexation, then benefits would fall by 0.3 percentage points each year compared to current law. This lower adjustment would accumulate through time so that after 10 years, beneficiaries would be seeing Social Security checks that are 3 percent smaller, after 20 years 6 percent, and after 30 years checks would be 9 percent smaller.

"While these reductions would be substantial, it is also important to consider whether this will cause the COLA to stop accomplishing its purpose of ensuring that benefits keep pace with the cost of living. The C-CPI-U is based on consumption patterns of all consumers. There is good reason to believe that the consumption patterns of Social Security beneficiaries are substantially different from the population as a whole in ways that would cause them to face a more rapid increase in the cost of living.

"First, health care and housing comprise a larger share of the budgets of the elderly; these items have seen larger price increases than most other goods and services. This is the main reason that an experimental elderly index (CPI-E) constructed by the BLS has on average shown a rate of inflation that is 0.3 percentage points higher than the CPI-W.

"The other reason for believing that the cost of living of the elderly may rise more rapidly than for the population as a whole is that they may have fewer opportunities for substituting across items to take advantage of changes in relative prices. This is both because their consumption basket (e.g. medical care and housing) may offer fewer opportunities for substitution and also because they are a less mobile population that may find it more difficult to adjust their consumption patterns.

"If it were the case that beneficiaries do in fact see a higher rate of increase in their cost of living than the population as a whole, then changing the basis for the COLA to the CCPI would undermine the original intention of Congress when it established the COLA. It would no longer be ensuring that the benefits of the elderly and other beneficiaries kept pace with the cost of living.

"If the goal of switching to a different CPI is to have a more accurate measure of the cost of living, then the obvious answer would to have the BLS construct a full elderly index (CPI-E) that would track the consumption and substitution patterns among elderly consumers. This index would then provide a basis for setting a COLA that more accurately reflected the actual changes in the cost of living experienced by seniors.

"It is difficult to see a legitimate reason for not constructing a full CPI-E, unless those pushing for switching the basis for the COLA to a chained index are simply using it as a backdoor to cut benefits. This is not only dishonest; it is an especially bad way to cut benefits. Those who would be hit hardest would be the oldest beneficiaries, who also tend to be the poorest.

"It would be useful to have a more honest discussion that separated the issue of an accurate COLA from efforts to cut benefits. Most retirees have relatively modest incomes presently, which is a strong argument against cutting benefits. However, if benefits are to be cut, there are more equitable routes than reducing the COLA."