Social Security COLA to be 5.8%

The Social Security Administration will today announce the 2008 Cost of Living Adjustment (COLA) to benefits will be 5.8 percent, the highest in over two decades. This increase reflects higher consumer prices and is designed to maintain the purchasing power of Social Security benefits against the effects of inflation. Here's an informative report from Martin Crutsinger with the Associated Press.

One related point I've been thinking about the past few days: as I understand current law, COLAs are applied only if the Consumer Price Index rises, but nominal benefits are not reduced if the CPI falls (i.e., if there is deflation rather than inflation). This effectively increases real benefit levels, since the purchasing power of constant nominal benefits would increase in the case of deflation. In essence, there's a 'ratchet effect' when deflation occurs.

Now, deflation isn't very common, but it's far from unknown. If we assume a future inflation rate of 2.8 percent (as the Social Security Trustees do) and also assume the historical standard deviation of 2.9 percent, we can project that future CPI inflation will be negative around 16 percent of the time. (One reason deflation was uncommon historically is that the mean rate of CPI increase was higher, at 4.2 percent from 1960 through 2006.) In certain cases where deflation was relatively common, this could increase Social Security's deficit, since benefits would increase faster than the taxes used to finance them.