Mark Miller: Remaking Retirement

Social Security COLAs: Good News and Bad News

Mark Miller

Here's some good news for seniors: Social Security will award a sizable cost-of-living adjustment (COLA) in 2012--and Medicare premiums won't clip your inflation raise much at all.

The Social Security COLA and Medicare Part B premium go hand in hand, because the premium is deducted from most seniors' benefits. Social Security benefits will be increased 3.6% starting in January--the first inflation adjustment in two years. And this year, the base premium for Part B--which covers doctor visits and other outpatient services--will rise just $3.50 per month to $99.90.

That means a senior receiving the average monthly Social Security benefit ($1,177) will see a net 3.3% gain in benefits--just under $39 per month. Meanwhile, the Part B deductible will be $140, a decrease of $22 from 2011.

There's also good news for the relatively small number of high-income seniors who pay surcharges on their Part B premiums. They will see their total Part B costs plunge next year.

But don't chalk up the lower-than-expected Medicare Part B premium to moderating health-care expenses. Instead, it mainly reflects the fact that Part B costs will be spread across a much larger base of beneficiaries next year, due to the complicated interaction between Social Security COLAs and Medicare.

The Background
Under the formula that governs Social Security COLAs, no increases were awarded in 2009 or 2010. But, although Part B premiums rose sharply both of those years, about 75% of Medicare beneficiaries were "held harmless" against the increases. That's because, by law, most beneficiaries can't be subjected to higher Medicare premiums if it means that net Social Security benefits would fall.

Part B is structured so that beneficiaries bear 25% of total program costs. But the "hold harmless" exemption for the majority of seniors meant that in 2010 and 2011, that cost was spread among a much narrower base of beneficiaries--low-income beneficiaries whose premiums are paid by Medicaid (so-called "dual eligibles") and high-income seniors. In 2010, the base premium jumped to $110.50 from $96.40, and it rose to $115.40 in 2011.

This year, the relatively high COLA means most Medicare beneficiaries are eligible to pay the new Part B rate; that means the 25% of Part B costs will be spread across a far larger base of enrollees, bringing down the rate hike paid by each enrollee.

The high-income premium surcharges are paid by individuals with $85,000 or more in annual income, and joint filers with income over $170,000, and they scale upwards through four income brackets. Currently, the surcharges affect just 5% of seniors, but they are on track to hit 14% by 2019 under the new health-care reform law. The income threshold previously was indexed to inflation, but the Affordable Care Act froze the threshold at 2010 levels through 2019, starting this year.

But seniors already in the high-income group will see significant relief next year. Their total Part B premiums (base plus surcharge) will drop 13.4% (see chart).

High-Income Seniors Also Will See Lower Medicare Part B Premiums
Total Part B premiums will fall 13.4% across all income brackets
Income: Single
Income: Joint
Part B Monthly 2011
Part B Monthly 2012
$85k-$107k
$170k-$214k
161.5
139.9
$107k-$160k
$214k-$320k
230.7
199.8
$160k-$214k
$320k-$428k
299.9
259.7
>$214k
>$428k
369.1
319.7
Source: The Centers for Medicare and Medicaid Services

The Part B news comes as the fall Medicare enrollment period for prescription drug and Medicare Advantage plans is in full swing. Enrollment started earlier this year (Oct. 15) and runs until Dec. 7.

Average premiums for prescription drug and Medicare Advantage plans will fall 4% next year--but it's still critical for seniors to reshop their plans every year if possible. For example, among the top 10 drug plans--which cover 77% of enrollees--some are cutting premium prices, but six are raising prices.

High income seniors also pay surcharges for Part D prescription drug plans, but those won't be changing significantly next year.

Misunderstood COLAs
Just mentioning the Social Security COLA angers many seniors. The absence of a COLA in 2009 and 2010 is one cause of their ire--and it's often directed at supposed miserly politicians in Washington. But in fact, the annual COLA has been on auto-pilot since 1975. Amendments to the Social Security Act passed in 1972 specified that an annual adjustment to benefits would be made automatically using a formula that aimed to pace the general inflation rate. Until that point, COLAs were granted only through a specific act of Congress; the process was messy and uneven--for example, during the 1950s and 1960s, COLAs were awarded only six times.

Currently, the COLA is set by averaging inflation for the third quarter, as reflected by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

No COLA was awarded in 2010 or 2011 due to a quirky inflation spike in the third quarter of 2008, due mainly to a sharp rise in energy prices; that resulted in a whopping 5.8% COLA for 2009. By law subsequent Social Security payments couldn't rise until the CPI-W exceeded the 2008 level.

This year, the third quarter CPI-W averaged 3.6%--again, due to higher energy costs, and food. (The chart below illustrates the dip and subsequent bounce-back of consumer prices over this period.)

But the COLA news also comes against a backdrop of debate about what inflation measure should be used to determine annual benefit adjustments. Many advocates for seniors and Social Security have argued for years that the CPI-W understates the inflation that impacts seniors--mainly health-care expenses. They've been pushing for adoption of a more generous measure that better reflects seniors' costs, called the CPI-E (for elderly).

The CPI-E aims to reflect the spending patterns of people over age 62, mainly health care. Used instead of the CPI-W, it would translate into monthly benefits about 6% higher for a retiree at age 92, according to the National Academy of Social Insurance (NASI).

But the key federal deficit reduction plans that have been advanced in Washington move in the opposite direction. These plans have recommended adopting a measure of inflation called the "chained CPI." A chained index reflects changes that consumers make in their purchasing across dissimilar items in response to price changes; the theory is that a spike in gasoline prices might, for example, prompt consumers to spend less on fuel and perhaps more on food.

Two deficit reduction commissions have advocated applying the chained CPI to federal benefit programs and to the income tax code--President Obama's National Commission on Fiscal Responsibility and Reform and the Bipartisan Policy Center's Domenici-Rivlin plan. It's one of the ideas being considered by the Congressional Super Committee on deficit reduction.

On the benefit side, a chained CPI would impact Social Security, civilian and military pensions and veterans' benefits, and Supplemental Security Income. On the revenue side, a chained CPI would be applied to inflation adjustments for tax brackets in the personal income tax code, effectively serving as a stealth tax hike by reducing tax bracket adjustments and subjecting more of individuals' earnings to higher tax rates over time.

According to the Congressional Budget Office, benefit adjustments could yield $217 billion over 10 years, with 52% of that--$112 billion--coming from reduced Social Security COLAs; income tax bracket creep would generate $72 billion.

If we do chain the CPI, it's going to be controversial. While most proposals to cut Social Security benefits push the changes far down the road, this change would begin impacting seniors almost immediately.

And while the Social Security Administration projects that the chained CPI will rise only about 0.3 percentage points less per year than the CPI-W, don't forget that this compounds over time for beneficiaries. NASI estimates show it translates to a monthly benefit cut of 8.4% for a retiree at age 92 (calculated from age 62, the first year of eligibility).

Seems like that certainly would take some of the fizz out of the COLA.

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living. The views expressed in this article do not necessarily reflect the views of Morningstar.com.