New paper: Social Security Cost-of-Living Adjustments and the Consumer Price Index

Clark Burdick and Lynne Fisher of SSA have an interesting paper in the latest issue of the Social Security Bulletin, which includes a lot of information I'd not previously known on the CPI and the CPI for the elderly (CPI-E), which some have proposed using to calculate Social Security Cost of Living Adjustments. Here's the summary of "Social Security Cost-of-Living Adjustments and the Consumer Price Index."

OASDI benefits are indexed for inflation to protect beneficiaries from the loss of purchasing power implied by inflation. In the absence of such indexing, the purchasing power of Social Security benefits would be eroded as rising prices raise the cost of living. By statute, cost-of-living adjustments (COLAs) for Social Security benefits are calculated using the Bureau of Labor Statistics (BLS) Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI‑W). Some argue that this index does not accurately reflect the inflation experienced by the elderly population and should be changed to an elderly-specific price index such as the Experimental Consumer Price Index for Americans 62 Years of Age and Older, often referred to as the Consumer Price Index for the Elderly (CPI‑E).

Others argue that the measure of inflation underlying the COLA is technically biased, causing it to overestimate changes in the cost of living. This argument implies that current COLAs tend to increase, rather than merely maintain, the purchasing power of benefits over time. Potential bias in the CPI as a cost-of-living index arises from a number of sources, including incomplete accounting for the ability of consumers to substitute goods or change purchasing outlets in response to relative price changes. The BLS has constructed a new index called the Chained Consumer Price Index for All Urban Consumers (C‑CPI‑U) that better accounts for those consumer adjustments.

Price indexes are not true cost-of-living indexes, but approximations of cost-of-living indexes (COLI). The Bureau of Labor Statistics (2006a) explains the difference between the two:

As it pertains to the CPI, the COLI for the current month is based on the answer to the following question: "What is the cost, at this month's market prices, of achieving the standard of living actually attained in the base period?" This cost is a hypothetical expenditure—the lowest expenditure level necessary at this month's prices to achieve the base-period's living standard. . . . Unfortunately, because the cost of achieving a living standard cannot be observed directly, in operational terms, a COLI can only be approximated. Although the CPI cannot be said to equal a cost-of-living index, the concept of the COLI provides the CPI's measurement objective and the standard by which we define any bias in the CPI.

While all versions of the CPI only approximate the actual changes in the cost of living, the CPI‑E has several additional technical limitations. First, the CPI‑E may better account for the goods and services typically purchased by the elderly, but the expenditure weights for the elderly are the only difference between the CPI‑E and CPI‑W. These weights are based on a much smaller sample than the other two indices, making it less precise. Second, the CPI‑E does not account for differences in retail outlets frequented by the aged population or the prices they pay. Finally, the purchasing population measured in the CPI‑E is not necessarily identical to the Social Security beneficiary population, where more than one-fifth of OASDI beneficiaries are under age 62. Likewise, over one-fifth of persons aged 62 or older are not beneficiaries, but they are included in the CPI‑E population.

Finally, changes in the index used to calculate COLAs directly affect the amount of benefits paid, and as a result, projected solvency of the Social Security program. A switch to the CPI‑E for the December 2006 COLA (received in January 2007) would have resulted in an average monthly benefit $0.90 higher than that received. If the December 2006 COLA had been adjusted by the Chained CPI-U instead, the average monthly benefit would have been $4.70 less than with current indexing. Any changes to the COLA that would cause faster growth in individual benefits would make the projected date of insolvency sooner, while slower growth would delay insolvency. Hobijn and Lagakos (2003) estimated that switching to the CPI-E for COLAs would move projected insolvency sooner by 3–5 years. A projection by SSA's Office of the Chief Actuary estimated that annual COLAs based on the Chained C‑CPI‑U beginning in 2006 would delay the date of OASDI insolvency by 4 years.

My take-away from this is that there isn't currently a perfect option for measuring price changes for the elderly. The CPI-W suffers from overstatement; the CPI-U is a better measure overall but not well-geared toward the elderly; and the CPI-E would need further development before it could be well utilized. For reform purposes, a well developed chained-CPI-E might be a good compromise: it would track the spending patterns of the elderly better than any current measure, and would likely reduce COLAs somewhat but not so much as using the current chained CPI. However, developing a new measure of inflation would be major undertaking by BLS.

Update: A friend emails that Social Security is not by law required to use the CPI-W. When BLS introduced the CPI-U SSA considered using it, but decided to remain with the CPI-W. What I'm wondering is whether this discretion implies that SSA could shift to the chained CPI without legislation.