Looks like you're going to get a COLA this year

Calculated Risk has a nice post on the rise in the CPI-W, the measure of inflation used to calculate Social Security COLAs. After several years in which the CPI remained below its historical high, meaning that no COLAs would be paid, a surge in prices over the past year -- presumably driven on the food and energy sides -- means that a COLA is likely to be paid in January, 2012. Here's a nice chart showing the CPI, marking the points where COLAs were calculated.


The bad news: this also means that Medicare Part B premiums will go up, since for most people they can't rise in years without a COLA. Also, the maximum taxable wage -- currently $106,800 -- will rise as well. Check out Calculated Risk's post here. Read more!

Video: Former CBO director Rudy Penner explains Social Security COLAs

From the Urban Institute, Rudy Penner explains why we won't be seeing a Social Security Cost of Living Adjustment this year.

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Adjusting to Reality in the New York Times

In this morning's New York Times I have an op-ed co-authored with Alicia Munnell, director of the Center for Retirement Research at Boston College, regarding the Social Security COLA and whether Congress should pass an ad hoc payment to seniors to make up for a COLA not being paid this year. We say no.

Click here to read why. I wrote on this subject at (much) greater length here and will have a related paper out soon.

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Now I know why I don’t watch CBS News…

For what little it's worth, here's how CBS News reported on the COLA controversy.

What's striking is that in a two-and-a-half minute segment – which is in-depth journalism by today's standards – CBS interviewed precisely no one who opposed paying an ad hoc COLA this year, despite ample reason to believe it's unjustified (when both the Wall Street Journal and the Washington Post editorialize against it, you can be pretty sure something's gone wrong).

Come on, people – at least pretend to get both sides of the story.

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Social Security benefits haven’t risen in generations. Really?

A friend brings to my attention an otherwise-interesting post by Kevin Drum discussing the recent Social Security COLA imbroglio. Drum makes the interesting point that annual COLAs give the impression of rising benefits even when the real buying power of benefits stays the same. (Economists call this "money illusion" and it's the source of a number of problems.)

But Drum takes things a bit far. He says that

Technical arguments about CPI calculations aside, the fact is that seniors haven't gotten a benefit increase for decades. It's just not the way the program works. But the fact that their checks keep going up makes it seem like they have.

Now, it's true that for current beneficiaries benefits haven't gone up, unless one pays attention to technical arguments regarding whether the current CPI overstates the rate of inflation. (Of course, if you do pay attention to those technical arguments, then – at least according to Northwester economist professor Robert Gordon – it's possible the that real value of benefits has been rising by 1 percent or more above the rate of inflation.)

But that ignores another point: the real value of benefits for new retirees has been rising consistently. That is, a new retiree this year doesn't get the same benefits as a new retiree last year; rather, he or she receives higher benefits. (Or at least they should; if I'm right about the new Social Security "notch" then they actually get lower benefits, but that's another story…). The chart below shows the real benefit level for new, medium wage retirees in years from 1998 through 2018.

As you can see, benefits increase pretty significantly: a new retiree in 2018 receive benefits around 29 percent higher in real terms than a new retiree in 1998. A prominent reform proposal "price indexing" would arrest this increase: rather than having benefits rise with wages from cohort to cohort, they would rise only with inflation. In effect, price indexing would be an inflation-adjusted freeze on future benefit growth. While this has been proposed, however, it's definitely not what we've seen over the past several decades.

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New paper: “A diet COLA for Social Security? Not really.”

Heading into SSA's expected announcement on Thursday of the 2010 Cost of Living Adjustment, I have a new paper in AEI's Retirement Policy Outlook series titled "A diet COLA for Social Security? Not really" that examines whether current beneficiaries are truly being hurt by not receiving COLAs over the next several years. The answer, in my view, is pretty clearly no. The 2009 COLA paid in January of this year inadvertently increased the real purchasing power of Social Security benefits by around 5 percent. As a result, Social Security will not pay COLAs until prices rise by around 5 percent, bringing the real value of benefits back to their intended level. In the meantime, however, real benefit levels will be above last year's, increasing the typical senior's buying power by around $1,000 before COLAs resume.

I've inserted a chart below showing the CPI-W over the last year or so. In mid-2008 there was a rapid increase in prices, such that a 5.8 percent COLA was granted in October of 2008. By the time the COLA began being paid in January of 2009, however, prices had dropped back below their 2008 levels. Once the CPI rises back to it's level at the 3^rd quarter of 2008 – a value of around 216 – COLAs will again start being paid.

While current retirees aren't being hurt, as I argued here, new beneficiaries – principally people aged 62 today, but also including new applicants for disability and survivors benefits – will be hurt, as they will be penalized by not receiving COLAs over the next two years but didn't receive the large 5.8 percent 2009 COLA. These folks deserve some help.

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The new Social Security notch

I have an article in Forbes outlining what could be a new "notch" for Social Security recipients. The original notch affected people born in the years 1917-21 and was due to a number of changes in the Social Security benefit formula during the 1970s. (See here for a Congressional report on the notch.)

The second notch affects mostly people who are 62 today and could result in an around 5 percent reduction in their Social Security benefits, which over time can end up as a lot of money. Put simply, the notch comes about because Social Security won't be paying Cost of Living Adjustments over the next two years. Here's the article, followed by a few comments:

Old-timers in Washington remember the Social Security "notch" as a quirk in the program's benefit formula that reduced payments for retirees born from 1917 to 1921. Eventually, a bipartisan Congressional commission concluded that the notch's effects were modest and did not require compensation. But not before members of Congress entered over 100 pieces of legislation to address the notch and senior advocacy groups, often under very dubious pretenses, reaped millions in contributions by claiming they could secure compensation for affected retirees.

A new Social Security notch coming soon should generate interest in Congress as it presents a much stronger case for help. Quirks in Social Security's formula for granting Cost of Living Adjustments (COLAs), interacting with a spike in inflation during 2008, could cause a typical 62-year-old couple to lose almost $25,000 in benefits over their lifetimes.

Social Security COLAs are calculated every October by comparing the third-quarter data of the Consumer Price Index for Urban Workers (CPI-W) with the previous year's numbers. An increase in the CPI results in a COLA the following January for retirees and other Social Security beneficiaries. Rising energy prices caused a 5.8% COLA to be ordered in the fall of 2008. However, plummeting prices between the fall of 2008 and the beginning of COLA payments in January 2009 caused the CPI as a whole to drop by around 5%. In effect, the 2009 Social Security COLA compensated retirees for inflation that no longer existed.

To make up for this overpayment, Social Security will pay no COLAs until prices rise back to their previous fall 2008 levels, which, according to the Congressional Budget Office, won't be until 2012. While seniors are upset by the lack of a COLA in the coming year, they actually benefited from the original overpayment. The overly large January 2009 COLA increased Social Security benefits purchasing power by around 5% above 2008 levels. For a typical retiree this is equivalent to an annual benefit increase of almost $700. Given that COLAs are designed merely to keep purchasing power constant, this is a large gain. Moreover, for all but the richest retirees, Medicare Part B premiums are not allowed to increase in a year without a COLA. This will save the typical senior almost $100 next year.

There is, however, one class of Americans who will lose big: people who turned 62 this year. 62 is the first age at which Social Security retirement benefits can be claimed, which means that individuals born in 1947 did not receive the 5.8% "windfall COLA" paid in January of this year. Like current retirees, however, today's 62-year-olds will not receive COLAs for the next two years. Inflation over the next two years will reduce the purchasing power of benefits for today's 62-year-olds by around 5% before COLAs resume in 2012. If today's 62-year-olds had received the "windfall COLA" of 2009, the lack of COLAs over the next two years would simply return their benefits to the proper level. But since today's 62-year-olds did not receive the 2009 COLA, the lack of COLA payments in 2010 and 2011 will have a significant negative impact on their lifetime benefits.

In addition, due to details of the Social Security benefit formula, this financial loss can't be avoided by delaying retirement until after COLAs resume in 2012. For a typical newly retired couple with a monthly benefit of $2,235, this penalty will cost them around $1,340 per year, for every year of their retirement. If they survive to a typical age of 83, these couples will lose almost $25,000 in lifetime benefits. While high-income households may shrug off a 5% cut in their Social Security benefits, for low earners every penny counts.

Americans turning 61 this year will also receive reduced benefits, though their cut will be around half that of 62-year-olds. Effects on younger individuals should generally be small, making this a true notch that affects only a small portion of retirees. While a Congressional ad hoc COLA for current beneficiaries is unjustified, given that the real purchasing power of today's benefits has increased, redress for new retirees over the next several years makes sense. Their reduced benefits stem from an unintended quirk in the benefit formula and restoring lost benefits will not make Social Security's precarious financing any worse. While Social Security benefits will need to be reduced as part of any reform, unintended cuts focused on a small group of near-retirees, rich and poor alike, make no sense.

It is time for Congress to adjust the Social Security benefit formula to make sure that neither unintended windfalls nor penalties take place.

I'm writing something now outlining the sources of the notch in more technical terms, but it mostly derives from the fact that Social Security benefits are based upon your average "indexed" wages. Indexing converts past earnings to make them comparable to earnings levels as of age 60. (For instance, if you earned half the economy-wide average wage when you were age 20, the indexed value would equal half the economy-wide wage as of age 60.) However, earnings after age 60 aren't indexed. This means that an increase in inflation that is later "revoked," as the 2008 increase was, would produce only a small increase in initial benefits but the lack of COLAs later would significantly reduce them. Current retirees aren't affected, as they first received an overly large COLA and later receive no COLAs, leaving their end benefits pretty much where they should be.

Here's one way to think about this: imagine that a bank inadvertently credited each of its customers accounts with an extra $1,000. It then discovered the error and said that it would deduct $500 from each customer's account over each of the next two years. In the meantime, though, bank customers could keep the interest on their accidentally higher balances. Now, current customers clearly aren't badly treated -- they got a bit extra today and will have it deducted over time. But now imagine if the bank made similar $500 per year deductions to the accounts of new customers, who hadn't received the initial $1,000 accidental credit. These new customers would obviously come out behind. In the Social Security world, current beneficiaries are the existing customers; they may gripe, but it's hard to say they've been badly treated. But today's 62 year olds are like the new customers, who have to pay back a credit they never received.

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Why seniors get upset when there isn’t a Social Security COLA

This Associated Press article gives a good idea of why seniors are so upset about the lack of a Cost of Living Adjustment (COLA) to Social Security benefits this year.

As I explained in a recent LA Times op-ed, in 2009, Social Security received a 5.8 percent COLA, the largest since the 1980s, due to large increases in energy prices in 2008. By the end of 2008, however, energy prices had dropped significantly, so much so that the entire increase in overall prices has been erased. The result is that the purchasing power of Social Security benefits is now significantly higher than it was in 2008: benefits rose, but overall prices didn't. Put another way, if prices decline but the Social Security COLA can't be negative, the real purchasing power of benefits increases. Likewise, if Medicare spending increase but those costs aren't reflected in higher Medicare premiums, that's like giving free money to Medicare beneficiaries. That's pretty much what we're experiencing now.

The problem is, most press reports – including this one – don't explain this very clearly. As a result, it plays as a story in which seniors are being hurt when that's really not the case.

I was quoted in the AP story saying,

"Seniors may perceive that they are being hurt because there is no COLA, but they are in fact not getting hurt," said Andrew G. Biggs, a resident scholar at the American Enterprise Institute, a Washington think tank. "Congress has to be able to tell people they are not getting everything they want."

Judging from the emails I've been receiving in response to this quote, the basic story regarding COLAs isn't being conveyed to the public.

Update: While the AP story correctly states that Social Security checks could fall because of rising Medicare Part D (drug benefit) premiums, it doesn't say by how much these premiums would rise. The answer, according to the Center for Medicare and Medicaid Services, is around $2. This covers about one quarter of the total increase in Part D costs, the rest of which are covered by the government. In addition, the rule against a negative COLA implies that Social Security benefits in 2009 were higher in real terms than in 2009 by around 5 percent. Since the average Social Security benefit is around $1,061, this implies an increase in purchasing power of around 53 dollars. On top of this, most retirees will receive increased Medicare Part B benefits without having to pay higher premiums, since premiums don't rise if there is no COLA.

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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.

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Obama discusses Social Security reform

Here's Barack Obama in Gresham, Oregon discussing Social Security reform, both his own ideas and criticism of Sen. McCain:



Obama says that a first priority is to stop spending the Social Security surplus, which implies balancing the non-Social Security "on-budget."

Second, he opposes any changes such as increasing the normal retirement age or reducing annual cost of living increases, because he believes his own plan -- eliminating the payroll tax ceiling, with a "donut hole" between the current ceiling of $102,000 and around $250,000 -- will be sufficient.

Obama proposes eliminating income taxes on Social Security benefits for individuals earning less than $50,000 in retirement. Obama says this will benefit around 7 million people, at an average of $1,400 per person. As this income tax revenue currently flows to Social Security, this will reduce the program's solvency. (While I don't know the source of his numbers, taking him at his word this would cost around $9.8 billion annually -- a lot of money, though relatively small on Social Security's scale.)

Obama also discusses his plan to automatically enroll individuals in workplace defined contribution pension plans. This is a very good idea, with bipartisan support. (See this proposal from the Retirement Security Project at the Brookings Institution.)

Update: A friend emails: "I guess Obama is unconcerned about generational equity. He wants to reduce taxes on people already getting the best deal (current retirees) and increase them on the generations already getting the worst deal (current workers)."

Me: Hard to deny that's the net result Sen. Obama's policies. To a large degree, Social Security is all about spreading cost burdens over time; making Social Security an even better deal for current retirees will require larger tax increases or benefit reductions on future participants. It's not clear why that's justified on either a policy or a moral basis, though electorally it's got an obvious appeal. Read more!

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.

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