How does the Social Security cost of living adjustment work?

With prices rising at the fastest pace in decades, many households have been feeling a new level of financial strain. Even in more typical years, though, inflation can erode the purchasing power of consumers shopping for everything from gas to groceries.

The good news for older Americans: The Social Security cost of living adjustment, or COLA, can provide some relief to retirees and other recipients struggling to make ends meet. Here's a look at how, and when, the program calculates that increased benefit amount.

The yearly cost of living adjustment (COLA) is a provision by the Social Security Administration (SSA) to help offset higher expenses through its retirement benefits, as well as those for spouses and survivors. The adjustment also applies to individuals who are disabled or blind and receive Supplemental Security Income. The percentage increase in one's benefit roughly coincides with the rate of inflation throughout the economy, which helps older adults keep up with rising prices.

The tricky part about implementing a COLA is that there's no perfect measure of inflation for a particular individual or household. For its part, the SSA uses a metric called the Consumer Price Index for Urban Wage Earners and Clerical Workers. The CPI-W, as it's often abbreviated, reflects an array of expenses that workers typically face, including food, shelter, clothing and transportation.

To arrive at the cost of living adjustment, the SSA compares the average CPI-W value for the third quarter of the prior year to the average number for the third quarter of the current year. The percent increase is the Social Security COLA that applies to benefits for the following year.

For example, there was a 5.9% jump in the CPI-W from the third quarter of 2020 to the same period in 2021. Therefore, the SSA implemented a 5.9% increase in COLA benefits starting in January 2022 (the disability COLA actually went into effect on Dec. 30, 2021).

Your Social Security benefit is based on your primary insurance amount, or PIA, which is caluclated through a benefit formula based on your earnings. Your PIA is then increased by the COLA, then truncated to the next lower dime. If your initial PIA is calculated at $1,800 and is increased by the 5.9% 2022 COLA, your new PIA would be $1,906.20. If you start claiming Social Security benefits at your normal retirement age (which, depending on when you were born, falls between ages 66 and 67), your benefit will be equal to your PIA. However, if you take benefits early (as early as age 62), your monthly benefit would be lower than the PIA. Delay receiving benefits until after you reach normal retirement age, and your benefit will be higher than your PIA.

Because some individuals have Medicare premiums deducted from their monthly Social Security benefit, the change in their net payout may not equal the COLA. The adjustment only applies to the benefit itself.

The SSA announced the 2023 COLA of 8.7% on October 13, 2022—in keeping with the pattern that historically, COLAs are announced every October for the following year.

With consumer prices continuing to soar this year, it's no surprise the 2023 COLA is even higher than it was for 2022. It marks the highest increase in more than 40 years.

While that may sound like welcome news if you're already claiming benefits, the adjustment means you're merely maintaining the purchasing power you had the year before. Because the SSA's inflation metric of choice looks at typical expenses for workers and not retirees, some argue it may not even fully succeed in that regard.

For example, older adults spend a disproportionate share of their income on medical expenses, which is a pattern that the CPI-W doesn't account for. In July, U.S. Senator Mazie Hirono (D-Hawaii) and Representative Ted Deutch (D-Fla.) introduced legislation that would instead peg the COLA to the Consumer Price Index for the Elderly (CPI-E), which the politicians suggest better represents retirees' expenses.

For most of the past three decades, inflation has been relatively mild, which meant the Social Security COLA was modest. For instance, during the 15-year period from 2007 to 2021, the average annual adjustment was 1.7%. In three of those years, a flat CPI-W meant no COLA was applied to benefits.

Here's a look at the annual Social Security COLA by year:

• January 2007: 3.3%
• January 2008: 2.3%
• January 2009: 5.8%
• January 2010: 0.0%
• January 2011: 0.0%
• January 2012: 3.6%
• January 2013: 1.7%
• January 2014: 1.5%
• January 2015: 1.7%
• January 2016: 0.0%
• January 2017: 0.3%
• January 2018: 2.0%
• January 2019: 2.8%
• January 2020: 1.6%
• January 2021: 1.3%
• January 2022: 5.9%
• January 2023: 8.7%

As you can see, the last decade was relatively stable until a sudden jump in inflation occurred as businesses ran into supply chain issues and global oil prices surged back from their early pandemic slump. The 5.9% increase in 2022 represented the largest cost of living adjustment since 1982. But the newly announced increase to 8.7% for 2023 tops that even further.

A substantial increase in benefits also could have other unforeseen effects. Namely, it could increase the tax bill for older adults with other income from wages, self-employment and interest.³ For instance, joint filers with combined income between $32,000 and $44,000—taxable income plus nontaxable interest plus half your Social Security benefit—may have to pay income tax on up to 50% of their Social Security payout. And if your combined income is more than $44,000, up to 85% of your benefit could be taxable.

That's not all—an increase in your taxable income also could mean paying more for Medicare Part B and Part D premiums. If you're in danger of being pushed into a higher tax bracket, then you may not pocket the entire COLA.

While the Social Security cost of living adjustment provides important relief to recipients, it may not alleviate the full impact of rising prices for everyone. If you're receiving wages and other taxable income, in particular, you should be aware of the potential tax consequences of your increased benefit.

It's also important to keep in mind that Social Security alone may not provide enough income to support your lifestyle in retirement. For the majority of older Americans, those monthly benefits replace less than half of their pre-retirement earnings. Therefore, you may need other assets whose value tends to keep up with inflation.

Creating a comprehensive financial strategy that protects your income from price hikes is one of the cornerstones of a secure retirement. Need help getting there? A local Thrivent financial advisor can offer time-tested financial guidance based on your unique needs.