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The COLA and Inflation Illusion or Money Illusion

One of the nice things about your Social Security income during retirement is that it is adjusted for the cost of living. The COLA or cost-of-living adjustment happens every year and depends on the year’s economic situation, especially inflation.

With the next COLA likely to be the largest we’ve seen in decades, more people are talking about it than ever before.

The inflation illusion or money illusion refers to a common misunderstanding about the COLA. That misunderstanding comes from the idea that the COLA has been too small in recent years. For reference, the one in January 2021 was only 1.3%.

Essentially, the misunderstanding is about the purpose of the COLA or its effect on your finances. The purpose of the COLA is to make sure that your Social Security income accounts for inflation. It should theoretically mean that you end up with the same overall buying power and economic circumstances (from Social Security at least) as you would have before.

At its most simple, think of the COLA as a way to offset inflation. Inflation would make your Social Security check not to go as far, but by using the COLA, Social Security benefits are supposed to keep up with general inflation. Read more about Analyze This: How Do RCM Analyzers Work?

Predicted 2022 COLA

The Social Security COLA for one year is determined by the 12-month wage inflation rate going through the previous year’s third quarter. This means that we won’t know what the 2022 COLA will be until we see the September numbers for inflation. Those figures should be released on October 13.

However, some estimates indicate that it will reach 6%. This would make it the highest since 1982 when it was 7.4%. Remember that the 2021 COLA was just 1.3%.

Other Potential Inflation Measures Social Security Could Use

The idea of the Social Security COLA relies on the fact that it isn’t flawed. While the COLA seems to work fine, there will always be proponents of other methods as well. Here are a few of the other popular inflation measurement and cost-of-living adjustment possibilities for Social Security to use.

CPI-W (Consumer Price Index for All Urban Wage Earners and Clerical Workers)

This is what the Social Security Administration uses at the moment, and the law states they must use it. It is commonly compared to the CPI-U (Consumer Price Index for All Urban Consumers), which is commonly reported as the CPI. In the past few decades, the CPI-W has risen about 0.1% more per year than the CPI-U.

CPI-E (Consumer Price Index for the Elderly)

This calculation accounts for the typical spending habits of the elderly. Compared to the CPI-W, the CPI-E has increased by 0.2% more annually.

Some congressmen argue that this should be the measure that the Social Security Administration uses. However, others argue that the difference is virtually non-existent, especially since 2002, so it would not be worth the effort to change it.

Covid-CPI

This CPI makes the argument that neither the CPI-W nor CPI-U accurately reflects inflation. Harvard Business School professor Alberto Cavallo is a proponent of this measure. A year ago, he calculated that the Covid-CPI was 0.6% higher than the reported CPIs. The most recent figures, however, show it is not 0.6% lower than the reported CPIs.

Small Changes to the COLA Have a Small Effect on Your Check

While you may feel the urge to get excited at a high COLA, you should not worry about it too much. After all, even a complete percentage point difference doesn’t make a significant difference. Considering that the average monthly benefit from Social Security is $1,543, a one percent increase in COLA would mean an extra $15.43 per month.

Other financial issues are likely to have a larger effect. It is important to have a retirement plan in place where you can see the impact of higher inflation. For some people, it won’t have a big effect. But for others, higher inflation can be devastating. Use accurate retirement planning software such as WealthTrace to see if you are on track to meet all of your retirement goals. At the very least play around with a simple free retirement calculator like Market Watch’s Retirement Planner.

Will Social Security Be Out of Money Soon?

The other major concern that many have about Social Security is when it will run out of money.

This was recently in the news again as the Social Security Administration’s chief actuary just released the most recent report. This report estimates that by 2034, the DI and OASI won’t be capable of paying 100% of the benefits. Given that these are two principal trust funds, this is important. It is also vital that this brings the estimate forward by one year.

This may seem to contrast with a previous report that Social Security finances were better than expected.

However, the actuary’s report confirms the information from last summer and fall that by 2034, the combined DI and OASI trust funds would run out of money. That means that the analysis hasn’t changed in a year with more time to analyze. As such, it is likely accurate.

It is also worth noting that the report about the financing being in “good” conditions was based on the previous estimate from the Congressional Budget Office of when the OAS trust found would be depleted. The previous estimate was 2031, but the recent one was 2032.

Overall, this means that the chief actuary’s estimate is better than the CBO’s. Either way, the current estimates are within a few years of each other. As such, they are likely to be reasonably accurate.

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