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As we get closer to the "fiscal cliff," more politicians have been discussing how to reduce the coming crushing burden of entitlements. That means Medicare and Social Security are in the crosshairs. Of course, most of those in Congress do not want to be the ones who actually cut anything for fear of losing votes. But one way they can impact social security payments without calling it a cut is to change how social security payments are indexed to inflation.

Currently social security payments 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. There is a good article about this here.

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. However, the purpose of this article is not to dive into that debate. I want to show how a reduction in the COLA used will impact a person's retirement situation.

It is generally believed that the chain-weighted CPI runs about .25% below today's COLA index. I want to show, using our Retirement Planner, what type of impact this will have on a couple's retirement plan over the years. 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

Total Investment Balance Today

$600,000 (50% in Taxable, 50% in IRAs)

Recurring Annual Expenses in Retirement

$60,000

Investment Mix

70% Value Stocks, 30% Medium Term Treasuries

Return Assumption Value Stocks

6% per year

Return Assumption Treasuries

1.5% per year

After running this couple's plan, I found that they will not run out of money in retirement and they will have a buffer of $75,000 (in today's dollar terms) when they pass away. It is important to note that I assumed the COLA index and the annual increase in their expenses both move by 3%.

I then 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 that this couple will now run out of money in retirement. Their entire buffer of $75,000 is wiped out, and they will run out of funds when they are 90.

The results are even more painful the younger a person is because the higher rate of actual inflation compounds by even more over time compared to the COLA index. For example, if this couple is 40 years old rather than 50, they would run out of money 11 years earlier than they would have had the COLA index not been changed.

Small changes such as the index used for social security can have a large impact on the retirement plans for many people. It is probably 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 how much their lifetime social security benefits will be.

I have also recommended trying to make up for any social security shortfall by investing in strong dividend payers throughout retirement. Companies such as Johnson & Johnson (NYSE:JNJ), Coca-Cola (NYSE:KO), Wal-Mart (NYSE:WMT), Exxon (NYSE:XOM), and Procter & Gamble (NYSE:PG) are great additions to a retirement portfolio. I recently wrote a popular piece on how a company like Procter & Gamble can change your entire retirement situation.

These companies I've listed have shown an ability to increase their dividends year after year, even in the face of recessions. By investing in strong dividend payers, you can worry less about social security because you will be receiving steady income from your dividends all throughout retirement.

Source: Changes To The COLA Index And The Impact On Your Retirement Plan