A cost of living adjustment (COLA) represents an annual percentage increase in consumer prices that is reflected in your Social Security benefits.
With a COLA, your monthly Social Security payment is indexed for a particular measure of inflation, which means that after that tracker of inflation rises, your monthly income in retirement will rise with it.
This important feature sets Social Security benefits apart from defined benefit plans like pensions that pay a fixed amount each month regardless of the inflation rate. While inflation indexing during a one- or two-year period is not terribly meaningful, the value of this type of inflation protection increases dramatically over the 20 or 30 years a healthy person might live in retirement.
Understanding the history, benefits, and calculations of the Social Security COLA can help you stretch your retirement nest egg further.
Social Security COLA History
As a result of Congressional legislation enacted as part of the 1972 Social Security Amendments, Social Security benefits have been indexed for inflation since 1973. Initially, new legislation was required for each adjustment, making it difficult to keep benefits on pace with the high inflation at the time.
Starting in 1975, automatic COLAs occurred when the CPI-W—the Consumer Price Index for Urban Wage Earners and Clerical Workers—increased by at least 3%, to more efficiently increase Social Security payments with rises in price. However, lower inflation in the mid-1980s created the possibility of no annual COLA under the 3% trigger, so Congress eliminated it in 1986.
During periods of positive inflation, Social Security benefits still increase to reflect rising costs. But Social Security COLAs are now made based the rise in the CPI-W from the third quarter of one calendar year to the third quarter of the next calendar year, as measured by the Department of Labor's Bureau of Labor Statistics.
Although the average annual inflation rate from 1913 to 2020 is around 3%, the Federal Reserve targets an average annual inflation rate of 2% as it carries out monetary policy.
COLAs Preserve Buying Power
Inflation protection is designed not to increase the standard of living of a Social Security beneficiary but to maintain the purchasing power of income benefits over time, particularly during inflationary periods.
For example, assuming a 2% inflation rate, a person's income would have to increase by around 50% from age 65 to 85 just to maintain a consistent standard of living. If inflation were 4%, that income would have to more than double during those 20 years to keep the same purchasing power. The Social Security COLA aims to make it so that your purchasing power isn't eroded over time—so you can buy similar amounts of goods and services with your income as you did in prior years.
Social Security COLA Calculation
The amount of the increase depends on the CPI-W, which measures the change in the price of a basket of consumer goods. CPI-W is a version of that data and measures how a segment of workers—in urban clerical and other wage-paying jobs—are affected by the changes in prices.
A specific formula drives the determination of the COLA. A COLA occurs if the average CPI-W from the third quarter of the prior year to the same quarter of the current year increases by at least 0.1%. If the CPI-W decreases or increases by less than 0.05% (a figure that is rounded down to zero), there is no COLA and, hence, no change in Social Security benefits.
The decision about a new COLA is typically announced during the month of October. Any adjustment will apply to benefits paid in January of the next year.
COLAs Over Time
Throughout history, the Social Security COLA increase has varied, as has the Social Security maximum taxable amount , which is the maximum income that is subject to the Social Security tax. Since 1980, the annual COLA has been as high as 14.3%—in 1980, a time of high inflation—and as low as 0%—in 2010, 2011, and 2016.
The COLA increase was 1.6% for 2020, and the maximum taxable earnings amount for 2020 is $137,700. The COLA increase for 2021 is 1.3%, and the maximum taxable earnings amount that year is $142,800.
Taxable earnings include wages and net profits from self-employment.
COLA Impact on Income Limits and Benefits
Social Security retirement earnings caps also adjust with COLAs. Individuals who are not yet in the year during which they reach full retirement age and are receiving Social Security benefits have half of their earnings above a certain annual threshold taxed away by the federal government. In 2020, the threshold is $18,240, or $1,520 per month. In 2021, the threshold is $18,960, or $1,580 a month.
Full retirement age varies according to when you were born but is age 66 for those born from 1943 to 1954 and 66 and 2 months for those born in 1955.
During the year in which they reach full retirement age, Social Security recipients are taxed $1 of every $3 they earn above another threshold if it is reached before their birthday. That amount is $48,600, or $4,050 a month, in 2020 and $50,520, or $4,210 a month, in 2021. Starting in the month of the birthday at which they reach full retirement age, the earnings limits no longer apply.