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An Early Look at Social Security's 2020 COLA

Sean Williams, The Motley Fool

The big day is coming. In about two and a half months' time, the Social Security Administration will release its 2020 update that highlights all of the changes to the Social Security program in the upcoming year. Chief among these changes is the highly anticipated cost-of-living adjustment, or COLA.

COLA is a fancy way of describing the "raise" that the more than 63 million monthly beneficiaries will receive in the upcoming year to account for the inflation they've faced in 2019. With the price of goods and services rising, and more than 3 out of 5 retired workers reliant on Social Security for at least half of their monthly income, you can probably see why most recipients wait on the edge of their seats to find out how much extra they'll be receiving each month, beginning in January 2020.

But before we dive into an early look at Social Security's 2020 COLA, let me briefly walk you through the calculation process so you'll better understand why this is an early look, and why we'll soon have our concrete answer on COLA.

A person holding a Social Security card between their thumb and index finger.

Image source: Getty Images.

How, exactly, does Social Security determine cost-of-living adjustments?

Since 1975, the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) has been the program's inflationary tether. Prior to this, Congress had to call special sessions and vote on whether to increase the amount paid to beneficiaries. Suffice it to say that this was done on an arbitrary basis, and no raises were passed along during the entirety of the 1940s.

The CPI-W has eight core spending categories, each of which have dozens upon dozens of subcategories, all of which bear various weightings for the index. However, not all monthly CPI-W readings, which are published by the Bureau of Labor Statistics (BLS), are taken into account when determining Social Security's annual COLA. In fact, only readings from the third quarter (July through September) matter. While the other nine months might offer clues as to where inflation is headed and what areas of the economy are experiencing pricing pressures, only the three months during the third quarter actually matter toward determining Social Security's COLA.

When the BLS has announced the CPI-W readings for July, August, and September, the three are added together and divided by three, so as to determine a third-quarter average reading. That figure is then compared to the average CPI-W reading from the third quarter of the previous year. If the average CPI-W reading rises on a year-over-year basis, then beneficiaries receive a raise that's commensurate with the increase, rounded to the nearest tenth of a percent. If it somehow declines, which has happened on only three occasions since 1975, then benefits will remain static year over year. Benefits cannot decline due to deflation.

A senior man counting a fanned pile of cash bills in his hands.

Image source: Getty Images.

How much of a raise should Social Security beneficiaries be expecting in 2020?

With the BLS announcing July's Consumer Price Index data on Aug. 13, we have the first piece of the puzzle needed to determine Social Security's 2020 COLA... although we're still missing data from the other two important months (August and September).

According to the BLS, the CPI-W reading in July 2019 came in at 250.236, representing a 1.66% increase from the July 2018 CPI-W reading of 246.155. However, it should be noted that each successive month that matters for the calculation in 2018 had a higher CPI-W reading, leading to an average reading of 246.352 during the third quarter. On a purely hypothetical basis, the 246.352 average from the third quarter of last year and the 250.236 CPI-W reading from July 2019 suggest an increase of 1.58%. Using rounding, the early data would suggest that Social Security's COLA will be in the range of 1.6% to 1.7% in 2020. 

Although the BLS doesn't break out specifically what caused the CPI-W to rise to 250.236 in its monthly press release, it does do so for a relatively similar inflation index, the Consumer Price Index for All Urban Consumers (CPI-U). According to CPI-U data, energy prices, such as oil and electricity, have been a modest drag, while shelter and medical care, arguably two of the most important costs for seniors, have generated the strongest year-over-year inflation.

A visibly concerned senior man holding a mug in his right hand with a pile of bills in front of him.

Image source: Getty Images.

No amount of COLA can close this gap

Of course, the thing to remember about Social Security's COLA is that it's not designed to help program beneficiaries get ahead. Rather, it's a measure that was put in place so that beneficiaries didn't see their Social Security dollars gobbled up by inflation over time. Unfortunately, that's exactly what's happened.

According to The Senior Citizens League, the purchasing power of Social Security dollars for seniors -- retired workers make up 70% of program recipients -- has declined by 33% since 2000. In other words, what $100 in Social Security dollars used to buy in 2000 will now allow an individual to buy only about $67 worth of those same goods and services.

The biggest issue with Social Security's COLA is that the CPI-W is inherently flawed. As its official name suggests, the CPI-W tracks the spending habits of urban and clerical workers. Urban and clerical workers are typically of working age, not receiving a Social Security benefit, and they spend their money very differently than senior citizens. What winds up happening is that very important expenditures, such as shelter and medical care, are underweighted in the CPI-W, whereas less important costs to seniors, such as education, apparel, and transportation, have higher weightings, leading to seniors losing purchasing power on their Social Security dollars more years than not.

The greatest irony here is neither Democrats nor Republicans believe the CPI-W is doing a good job of measuring inflation. However, the solutions they've proposed are miles apart, meaning there's virtually no chance of gaining consensus or finding a middle-ground solution to improve how the rising cost of goods and services is measured by the program. This means that no matter what sort of "raise" is passed along to beneficiaries in 2020, it may not be keeping up with the true inflation that program recipients are contending with.

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