Proposed Changes To The COLA Index Could Dramatically Impact Some Clients' Retirement Plans

Currently, Social Security benefits increase with the rate of the Cost Of Living Adjustment (COLA) index. The COLA index used for Social Security is equal to the percentage increase in the consumer price index for urban wage earners and clerical workers (CPI-W) for a specific period. This index represents a basket of goods that only changes periodically.

However, there is discussion about changing the index used to the “chain-weighted” Consumer Price Index (CPI), which supposedly accounts for substitutions consumers make when prices of certain goods rise. Critics of the proposal, which inlcudes AARP, says the proposal to use chained CPI actually underestimates inflation costs for seniors, who spend more on health care than average Americans.

There are many flaws in the chain-weighted CPI methodology and some believe it is just one more way the government has understated true inflation and pushed more people into higher tax brackets. But the purpose of this article is not to dive into that political debate. I want to show how a reduction in the COLA used will impact a client’s retirement plan.

It is generally believed that the chain-weighted CPI runs about .25% below today’s COLA index for social security. Using my Retirement Planner app, here an illustration of the financial impact this would have on a couple’s retirement plan. Let’s start with some assumptions:

Inflation (CPI and COLA)	3.00%
Current Age of Both People	50
Age Of Retirement	65
Age When Social Security Is Taken	67
Age When Both People Have Passed Away	95
Social Security at age 65 (combined)	$45,000 per year

I ran a scenario to see what happens if the federal government moves the COLA index to the chain-weighted CPI and the COLA index is reduced by 0.25% per year vs. the growth rate in their expenses. In this scenario I assumed their expenses grow by 3% per year and the COLA index grows by 2.75%. I found the following:

Lifetime Cumulative Benefits Before COLA Change (In Today's $)	Lifetime Cumulative Benefits After COLA Change (In Today's $)	Difference
$1,296,123	$1,202,033	$94,090

Combined Average Annual Social Security Payments Before COLA Change (In Today's $)	Combined Average Annual Social Security Payments After COLA Change (In Today's $)	Difference
$45,000	$41,737	$3,263

Although the decrease of 0.25% in the COLA index might not sound like much, the compounding of this change over time has dramatic results.

The cumulative Social Security benefits that this couple can expect to receive declines by over $94,000 in today’s dollar terms. Their average annual Social Security benefit will decline by over $3,200 in today’s dollars.

This is a big change for many people and can mean the difference between retiring comfortably or putting off retirement for several years.

It's best to assume that Social Security benefits will be cut in the future, one way or another. I have recommended for some time now that people should be conservative with their assumptions when it comes to valuing lifetime Social Security benefits. This is one more reason why advisors should warn clients not to expect to receive what was promised.

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