The Social Security COLA for 2017 Has Been Announced

Today the Social Security Administration (SSA) announced the cost-of-living adjustment (COLA) for Social Security benefits next year will be 0.3 percent. This seemingly small increase in benefits should not be seen as bad news for Social Security beneficiaries, as it simply reflects the fact that prices have only slightly exceeded their levels from two years ago. If anything, the current method of determining the COLA tends to overcompensate beneficiaries for changes in inflation.

Social Security beneficiaries receive automatic COLAs each year to ensure real benefits stay constant and do not erode with inflation. Social Security calculates the COLA based on the annual change in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) in the third quarter of each year. Beneficiaries received no COLA in 2016 because inflation was actually slightly negative in 2015, and benefits are never decreased when there is deflation. This means the COLA for next year is actually based on the change in the CPI-W since 2014.

The COLA for 2017 will be the lowest non-zero increase since automatic COLAs began in 1975; in fact, no other positive COLA has been below 1 percent. But that owes to the fact that inflation has been considerably lower than it has in the past. Recent inflation has been low enough that Social Security recipients will only need a small increase to maintain the purchasing power of their benefits.

In fact, there is broad consensus that the CPI-W generally overstates inflation because it looks only at price changes for a small sample of goods and does not account for how consumers substitute similar products based on relative prices. The Consumer Price Index for All Urban Consumers (CPI-U) corrects for the small sample, covering 87 percent of the population versus 32 percent for the CPI-W, and is used to index many other federal programs, but only the chained CPI also accounts for substitution effects. That is why the chained CPI is widely considered to be a better and more accurate measure of inflation than either the CPI-W or CPI-U – not just for Social Security COLAs, but for all federal programs and tax provisions that are indexed to inflation. The initial numbers released by the Bureau of Labor Statistics (BLS) suggest that if the 2017 COLA was based on the chained CPI it would be 0.7 percent (after also producing no COLA for 2016), but annual inflation as measured by the chained CPI is generally about 0.25-0.3 percentage points lower on average than inflation measured by the CPI-W.

BLS also produces an experimental price index called the CPI-E intended to measure changes in the cost of living for the elderly, and some have argued the CPI-E should be used to determine the Social Security COLA. But as BLS and CBO have pointed out, the CPI-E suffers from the same substitution bias and small sample bias as the CPI-W, as well as a number of other technical shortcomings of its own. And it is not clear if it would be appropriate to use an inflation measure for a particular subgroup to calculate inflation adjustments in general, particularly as Social Security provides benefits to many beneficiaries who are not elderly.

In addition to the increase in benefits, the COLA has several other implications. Because there is a COLA this year, the maximum amount of earnings subject to the Social Security payroll tax will be allowed to grow with average wages, rising from $118,500 to $127,200 next year. The taxable maximum does not increase when there is no COLA, so this year's increase reflects two years of growth; ideally, lawmakers would sever this link since lack of inflation has no bearing on wage growth that isn't already captured. Another effect of the COLA is that because Medicare's "hold harmless" provision limits Part B premium increases to the dollar amount of the COLA for most enrollees, about 70 percent of seniors will see only a small rise in their premiums, an issue we will discuss more in a subsequent blog.

Protecting benefits from being eroded by inflation helps make Social Security an important source of financial security for many seniors who otherwise rely on fixed incomes. But deliberately using a flawed measure of inflation to provide all retirees with extra benefits beyond what is warranted is poor policy. Thoughtful Social Security reforms that put the program’s finances on a sustainable path while enhancing benefits for those in need would improve retirement security for current and future generations.