You may be familiar enough with the term COLA in the context of Social Security to know that it's not a soft drink — it's an acronym that stands for "cost of living adjustment." Here we'll provide some information on what exactly COLA means and how it could impact your retirement.

The Meaning of COLA

A cost of living adjustment is an increase in benefits to offset the impact of inflation on the cost of living. Inflation is a general increase in the price of goods and services over time, and COLAs aim to prevent inflation from decreasing the purchasing power of benefits.

What Do COLAs Affect?

The U.S. Social Security Administration (SSA) sets cost of living adjustments for both Social Security and Supplemental Security Income program beneficiaries. For new retirees, it's especially important to understand how cost of living adjustments apply to benefits administered by the SSA.

Social Security benefits are designated for retirees and their spouses or widows. Supplemental Security Income benefits go to recipients with limited income or a disability, or to people who are age 65 and older, as well as to some children who have disabilities. Cost of living adjustments for both programs are generally the same for both Social Security benefits and Supplemental Security Income benefits.

Federal cost of living adjustments also apply to the benefits of veterans with disabilities and the pensions of federal government retirees. Altogether, about 70 million Americans receive federal benefits that are subject to cost of living adjustments.

History of COLAs

The Social Security Administration first began making automatic cost of living adjustments to its benefits in 1975. Congress authorized the adjustments in the 1972 amendment to the Social Security Act. Before then, benefit increases only happened through special legislation.

From 1975 to 1982, cost of living adjustments became effective with benefits payable in June and received in July. Since 1982, they have been effective with the December payments that beneficiaries receive in January.

Average Benefit Adjustments

If consumer prices stay flat or fall from year-to-year (meaning there was no inflation), there is no cost of living adjustment. This has happened only three times in history. In 2009, 2010 and 2015, the Social Security Administration determined that there would be no cost of living adjustments for the next year.

Kiplinger magazine notes that on the first two occasions of a zero adjustment, prices were down due to the U.S. economy struggling to recover from the Great Recession. In the third instance, it was the sharp decrease in oil prices that nixed any increase in benefits.

The highest Social Security benefits adjustment in history was 14.3% in 1980, when the inflation rate was 13.5%. Over the past ten years, the average COLA has been 1.6%.

How the Adjustment Is Calculated

The Social Security Administration bases the percentage of each cost of living adjustment on the annual increase in a statistical measure from the U.S. Department of Labor called the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

What Is a Market Basket?

The CPI-W represents the change in prices that consumers pay for a fixed set of 175 consumer goods and services called a "market basket." Items in the basket include food and beverages, housing, furniture, clothing, transportation, health care expenses and even haircuts. Taxes and investment items, such as stocks, bonds, real estate and life insurance, are not included.

In calculating cost of living adjustments, the Social Security Administration looks at the increase in the CPI-W between the third quarter of the previous year and the third quarter of the current year.

For 2021, the COLA for Social Security and Supplemental Security Income benefits was 1.3%. This was down from the 1.6% bump beneficiaries received in 2020. One reason for such a modest increase was that energy prices fell in response to lower demand for transportation fuel during the COVID-19 lockdown. With inflation growing more rapidly in the first few months of 2021, many analysts are predicting a much higher adjustment to 2022 benefits.

Impact on Social Security Benefits

Each cost of living adjustment from the Social Security Administration results in an increase in your monthly Social Security retirement or Supplemental Security Income benefit. To determine how much more you will receive, the Social Security Administration multiplies the current primary insurance amount of your benefit by the percentage of the COLA.

Your primary insurance amount is based on a formula that relates to your history of work earnings. This determines the amount of benefits you will be eligible to receive at your full retirement age. If you retire before your full retirement age, your actual benefit will be lower than your primary insurance amount. If you retire after your full retirement age, it will be higher.

Consider how the 1.3% adjustment for benefits payable in January 2021 affected three types of beneficiaries: The average retired worker saw a $20 increase in monthly benefits, from $1,523 to $1,543. Benefits for spouses of retired workers increased by an average of $10 a month, from $791 to $801. The monthly benefit for disabled workers went up an average $16, from $1,261 to $1,277.

Why COLAs Matter to Retirees

The Social Security Administration estimates that in 2021, an average of 65 million Americans will receive a Social Security benefit. Nearly nine out of 10 people who are 65 or older in the U.S. receive Social Security benefits, and among those senior beneficiaries, 50% of married couples and 70% of unmarried people derive 50% or more of their income from Social Security, according to the agency's most recent data. In that same group, 21% of married couples and 45% of unmarried people rely on Social Security for more than 90% of their income.

Without adjustments to Social Security benefits to counter the rising cost of living, it becomes more difficult for most retirees to make ends meet. Even for those who have additional sources of retirement income, those automatic COLAs can make a difference.

Key Takeaways

• The purpose of the Social Security Administration's cost of living adjustments is to prevent inflation from eroding the purchasing power of its benefits.
• The Social Security Administration has been making automatic cost of living adjustments since 1975 under the authority of the 1972 amendment to the Social Security Act.
• When the prices of certain consumer goods and services go up, Social Security and Supplemental Security Income benefits increase for that year.
• When there is no increase in the inflation rate for a hypothetical basket of goods and services, there is no cost of living adjustment to benefit amounts.
• There have been only three instances since their establishment when COLAs have not occurred.
  

Cost of living adjustments are vital to the financial security of retirees, especially those who depend on Social Security for a major portion of their income.