There is a lot of advice out there about Social Security – most of which is based on Social Security being fully inflation indexed.
However, as we will establish in this first in a series of analyses, Social Security is only partially inflation indexed. As a matter of design, it does not fully keep up with inflation.
Sound like an obscure difference?
“Partial inflation indexing” is little understood by the general public, but it could transform your standard of living – along with the quality of life of millions of others – in the years and decades to come. Indeed, partial inflation indexing can mean effectively having only 11 months of benefit purchasing power- or even 8 months – to cover 12 months of expenses each year.
Now if coming up a month or more short for the value of the benefits received each year would have a significant impact on your life in retirement, then fully understanding partial inflation indexing could change your financial planning, your decision on when to retire, and your decision on when to begin claiming Social Security benefits
There are many aspects to partial inflation indexing and they cumulatively build upon each other. Our starting point in this first analysis is going to be some seemingly obscure technicalities built into the details of how Social Security actually works that many people have likely never even thought about.
The Theory Of Full Inflation Indexing
Inflation is not an accident, but is created by the Federal Reserve as a matter of policy. The prevailing economic theory is that a slight annual reduction in the purchasing power of the dollar is good for economic growth.
Since the United States went off the gold standard in 1933 and began setting the goal of creating a low to moderate rate of inflation each year, inflation has averaged a little over 3.5% per year. In total the dollar has lost about 95% of its value over the past 84 years.
The impact of inflation is not felt evenly, and people in the workforce can keep up when their wages (hopefully) increase with inflation. However, retirees generally have the greatest exposure to inflation of any age group, as the value of their savings steadily diminishes and they no longer have wages to increase.
The Social Security Administration provides an annual COLA or Cost-of-Living Adjustment, which is intended to offset this inflation that is deliberately created by the Federal Reserve.
In theory, with full inflation indexing, we are supposed to get something like the graph above. The green line of benefits goes up every year by an amount equal to the long-term average rate of inflation. These increases fully offset the declining purchasing power of the dollar, and this means that the retiree can rely on the red line of constant purchasing power.
So no matter what the rate of inflation is each year or how far out in time we are looking – Social Security is in theory supposed to reliably deliver the same amount of purchasing power.
How Social Security Actually Works – The Inflation Lag Calendar
What is shown above is not, however, how Social Security actually works. To understand the difference we need to get into the details of those annual benefit increases. These details may sound a bit technical, to begin with – but they are well worth understanding, because they can change your personal standard of living for years or even decades.
Social Security benefits can only increase in January, and then they remain at the level of the January payment for the rest of the year.
The amount of the benefit increase (if any) is not based on average inflation over the prior year. Instead, the amount of the benefit increase is based on the average of the July 1st, August 1st, and September 1st inflation indexes for the quite obscure CPI-W inflation index (more on that in the next analysis).
While this is referred to as the third quarter average, it is a little odder than that. As an example, the difference between the July 1st and August 1st inflation index measurements is based upon price data that is (primarily) gathered over the course of the month of July. Because the inflation that will occur in a month is not known on the first day of that month, what is really being reported for the three dates of 7/1, 8/1 and 9/1 is based on inflation measurements that primarily occurred during the months of June, July and August.
To understand how this can change standards of living for retirees across the country, I’ve created a Social Security Inflation Lag Calendar, which is broken out into four color-coded zones.
First Calendar Zone – Inflation Occurs, But Is Not Measured
The first zone is that of the dark blue bars when inflation occurs, but is not measured for inflation indexing purposes, or at least not by the Social Security Administration. This period of non-measurement includes the nine months of September through May each year, which means that 75% of each year is not taken into account. (The index for the CPI-W is in fact calculated by the Bureau Of Labor Statistics every month, but nine months are ignored each year by the Social Security Administration.)
Most annual inflation occurs during this time, which means the dollar is steadily dropping in value (assuming a level monthly rate of inflation). If the dollar has a value of 100% in the middle of our summer measurement period (the light blue bars) – that means it has to be worth more before then.
With a historically average 3.5% rate of inflation, that means that the dollar in September needs to have a purchasing power of $1.029. This is down to $1.026 in October, to $1.012 by March, and $1.006 by May.
If there are any temporary spikes in inflation during those nine months, such as with energy or food prices, that are not still there by the following summer – they are simply gone, they never existed as far as the government is concerned. There is no repayment, there is no catch-up.
Second Calendar Zone, Inflation Index Measured
The second zone is the light blue bars of the summer months when inflation is actually measured. The CPI-W indexes for July 1st, August 1st and September 1st are averaged together and compared to the what the three month average was in the last year in which there was a benefit increase. Whatever the percentage increase is, becomes the percentage increase in Social Security payments that will occur in the following January.
For the purposes of this first analysis in a series, we will assume that this measurement is entirely fair and accurate. The beneficiary gets an adjustment that represents 100% of what they should be getting, to entirely keep up with inflation.
As can be seen in the Inflation Lag Calendar, this assumed fair setting of the value of Social Security benefit payments at 100% includes the price increases that occurred over the course of the month of July, the middle of our measurement zone (which is reported as the August 1st CPI-W).
Third Calendar Zone, Lag Between Measurement & 1st Payment
The third zone of the dark green bars is the lag between when inflation is measured, and when the first payment made upon that measurement is actually made.
Because inflation is ongoing – the value of the benefit payment is declining each month before that first payment. What was equal to a fair $1.00 in purchasing power in July is down to $0.994 by September, and $0.986 by December.
It should also be noted that a cut-off has occurred, and inflation that occurs during the fall of 2019 (in this example) will not impact the 2020 payments, regardless of the degree of inflation. Even with major and sustained inflation, it will not be measured until the summer months of 2020, and there will be no payment adjustment until January of 2021. Which means that the lag between when expenses increase and when benefits increase in response can be as great as 16 months.
Fourth Calendar Zone, Inflation-Adjusted Payments Made
With level inflation, price data collected during the month of July, (the middle of the June to August measurement zone), is effectively what determines the dollars that are available to make expense payments over the full month of January in the following year. So there is an effective full six-month gap between the middle of the average measurement month and the middle of the first payment month.
