The Calculation: Why The Social Security COLA Will Sink In 2020

by: Tipswatch
Summary

The Social Security Administration uses a complex formula, and an unusual inflation index, to set the annual COLA increase.

Once again, the Social Security COLA looks like it will be lower than overall U.S. inflation. (That wasn't true for the 2019 increase, however.).

At this point, a COLA increase in the range of 1.6% to 1.8% looks likely, but a lot can change in the only months that matter: July, August and September.

Social Security Administration In its annual report issued in April, the Social Security Administration projected a likely 1.8% cost-of-living-adjustment (COLA) for Social Security recipients in 2020. That looks like a reasonable estimate, but possibly a bit high.

The COLA formula is ridiculously complex and little understood. Is it related to U.S. inflation? Yes, but not the inflation index you hear about each month. Does it reflect 12 months of U.S. inflation? Not really. Does it underestimate actual U.S. inflation? Most years, yes.

U.S. inflation (measured by CPI-U) is running at 1.6% as of June, but the Social Security Administration doesn't use CPI-U. Instead, it uses the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). For that index, the June annual increase was lower at 1.4%.

The Index

CPI-W includes data only from households with at least 50% of income coming from clerical or wage-paying jobs. I've noted in the past that CPI-W generally lags slightly behind CPI-U, which means the Social Security COLA also generally lags behind the standard measure of U.S. inflation.

Last year, however, was an exception, with CPI-W running higher than official inflation, resulting in a 2.8% COLA for Social Security recipients at a time when inflation was running at 2.3%.

CPI-W isn't widely tracked or reported, but the Bureau of Labor Statistics updates the index each month in its overall inflation report. In June 2019, for example, the index was set at 249.747, for a 12-month increase of 1.4%. Last year in June, the 12-month increase was 3.1%, but the eventual COLA for 2019 came in at 2.8%.

Right now, you could say, "Well, CPI-W is running at an annual rate of 1.4%, so that will likely be the COLA increase for 2020." But that's not true. In fact, the June number has a tendency to overstate the eventual COLA, as shown in this chart for the last 10 years:

June CPI-W

June sets the baseline for the COLA increase, but then we come to ...

The Formula

The SSA doesn't look at a full year's data to determine the COLA. Instead it uses the average CPI-W index for the third quarter -- July, August and September. Here is the language from the SSA site:

A COLA effective for December of the current year is equal to the percentage increase (if any) in the average CPI-W for the third quarter of the current year over the average for the third quarter of the last year in which a COLA became effective. If there is an increase, it must be rounded to the nearest tenth of one percent. If there is no increase, or if the rounded increase is zero, there is no COLA.

This is interesting wording, because it means that the SSA eliminates years where inflation was zero or negative, meaning there isn't a "bounce-up" effect on benefits after a year of deflation. Instead, it goes back to the last year where there was an increase in benefits. But that won't matter in this 2019 calculation, because the COLA rose 2.8% last year.

So, although 12-month CPI-W was up 1.4% in June, that number is only the baseline for the 2020 COLA increase. The only inflation numbers that will matter are for the third quarter: July, August and September. Last year, the CPI-W index averaged 246.352 in the third quarter. The June 2019 index was set at 249.747, or 1.4% higher than that average. So if we have zero inflation in the third quarter of 2019, the Social Security COLA be set at 1.4%.

Projecting the 2020 COLA

I have criticized the Social Security Administration in the past for projecting higher COLA number than looked likely (this was true the last two years), but I think the SSA is using these numbers for financial projections. They aren't meant to be set-in-stone estimates. And they are made in April, well before the SSA has relevant numbers.

And the truth is, accurately predicting future inflation is nearly impossible. Plus, the summer months can be especially volatile. (In 2017, major hurricanes struck Texas and caused a spike in oil prices in September, for example.) This year, could we see an inflation shock from trade wars or military actions in the Persian Gulf?

But at this point, CPI-W is running at 1.4% over the last year, so you'd expect a continued trend of about 0.1% a month in July, August or September. Or ... 0.0%. Or ... 0.2%. All of those seem possible.

So let's take a look at how differences in the 3rd-quarter inflation rate would alter the 2020 COLA:

2020 Social Security projection One thing to note is that the CPI-W grew very slowly in the third quarter of 2018, after starting from a baseline of a 3.1% increase in June. That resulted in a COLA of 2.8%, lower than looked likely.

This year, CPI-W in the 3rd quarter will start with a baseline of 1.4%, but then be compared to very weak numbers from the 3rd quarter of 2018. That might mean the eventual COLA increase will come in higher than expected.

The SSA has projected a 1.8% COLA increase for 2020. It could happen. My estimate would be in the range of 1.6% to 1.8%. Is 1.4% possible? Yes, but I think the weak inflation of the 3rd quarter of 2018 makes that unlikely.

Then again, just like the SSA, I'm not making a set-in-stone estimate. It's an educated guess.

What this means for Social Security recipients

The Social Security Administration estimates that the average benefit in 2019 for all retired workers is $1,461. So an increase of 1.6% would raise that to $1,484; an increase of 1.8% would result in a benefit of $1,487. If you are in the Social Security "limbo" period -- older than 62 but not yet taking benefits -- your future benefits would also climb these percentages.

However, recipients can also expect that Medicare Part B costs may rise in 2020, which may subtract -- at least partly -- from the higher benefits. The base premium is now $135.50 a month, up $1.50 from a year ago.

We won't know the actual COLA number until 8:30 a.m. EDT on October 10, 2019, when the Bureau of Labor Statistics releases the September inflation report and completes the data needed for the 3rd quarter average of CPI-W. I will be tracking these numbers for July, August and September as each inflation report is issued.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he recommends can purchased through the Treasury or other providers without fees, commissions or carrying charges.