Friday, April 5, 2013

How important is the Social Security COLA adjustment


Changing the Social Security COLA:

Question:   President Obama has proposed basing future Social Security COLAs on the chained CPI rather the traditional CPI.   Assume a person retires at age 62 gets a first-year benefit of $15,000 and receives benefits until they die on their 83rd   birthday. 

What is the impact of the COLA adjustment if the chained CPI is 1.8% and the traditional CPI is 2.0%?  (This is our low-inflation scenario.)

What is the impact of the COLA adjustment if the chained CPI is 7.2% and the traditional CPI is 8.0%?  (This is our high-inflation scenario.)

I have assumed that inflation, both traditional and chained, are 4 times larger in the high-inflation scenario than in the low-inflation scenario.

Answer:   Let’s consider two measures of the impact of the benefit change.  The first is the benefit in the final year of life.   The second is the sum of benefits during retirement.

Benefits are set at the beginning of the year.  The formula for the benefit after 20 years is

B20=$15,000*(1+.inf)20



For inf=0.02, benefits after 20 is $22,289.  For inf=0.018, benefits after 20 years is $21,431.  The change in the COLA led to a decrease in benefits in the 20th year of around 3.8%.

For inf=0.08, the annual benefit after 20 years is $69,914.  For inf=0.074 the annual benefit after twenty years is $60,254.  The change in the last-year benefit is around 13.8% because of the policy change.

A spreadsheet is used to calculate the impact of the benefit change from age 62 to age 83.  In the low-inflation scenario, the change in the COLA results in a 2.1% decline in lifetime benefits.  In the high-inflation scenario, the change in the COLA results in a 6.8% decline in Social Security benefits.

Changes in the CPI are a tough issue for me.    

Interested readers should see my policy posts on this topic.



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