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Social Security Benefits’ 2023 COLA: Is It Enough?

The 8.7% cost-of-living adjustment next year is historic, but more needs to be done to improve retirement security.

A man and a woman discuss financials in front of a computer screen.

The eye-popping 8.7% bump in Social Security benefits for 2023 served as a reminder of one of the program’s most valuable features—built-in, automatic protection against inflation. You can’t find that in any other retirement benefit.

But did you know that the annual automatic cost-of-living adjustment, or COLA, hasn’t always been a feature of Social Security?

The first automatic adjustment was paid in 1975, following legislation enacted by Congress in 1972. As such, it is one of hundreds of expansions of benefits enacted by Congress since Social Security was signed into law in 1935—although one of the most important. And the COLA serves as a reminder that Social Security is not static: As a country, we could choose to respond to today’s retirement challenges by enhancing the program further.

Social Security COLA History

Today, the Social Security COLA is determined using an automatic formula based on the Consumer Price Index for Urban Wage Earners and Clerical Workers, or CPI-W.‌

Social Security computes the COLA by averaging the CPI-W figures from the third quarter of each year and then comparing that with the previous year’s figure.

Before that, Congress awarded COLAs only periodically and generally in large amounts. For example, there was a 10% increase in 1971, a 20% increase in 1972, and two increases in 1974 totaling 18%.

Congress has made numerous changes to Social Security over the years, most often expanding benefits. For example, the pool of covered workers was expanded—the program initially covered only employment in commerce or industry, which was equal to about half of the jobs in the country. The disability insurance program was also created, survivor and dependent benefits were added, and the minimum age for receiving benefits was reduced. Importantly, benefit levels also were indexed to reflect wage growth over the worker’s lifetime, although getting that change right required more than one attempt.

To pay for these changes, payroll tax rates were increased along the way. The rate paid by both employers and employees was just 1% in the early days of the program, rising gradually to 5.35% in 1981. The rate has been 6.2% since 1990.

Keeping Even vs. Adequacy

The Social Security COLA is one of the program’s most valuable features—you really can’t find this type of guaranteed inflation protection in any commercial annuity. Of course, it’s possible to hedge inflation using Treasury Inflation-Protected Securities or I Bonds. Some also argue that stocks are a hedge against inflation; that might be so over the long haul, but in any given year markets can (and do) move in different directions than inflation rates. Nevertheless, none of these investment choices are automatic, and they all entail risk.

With general inflation running hot, this year’s automatic COLA formula produced that unusually large 8.7% increase. At the same time, the Medicare Part B premium will decline by $5.20 per month, delivering an extra dollop of relief.

But the good news on the 2023 Social Security benefits’ COLA doesn’t change the broader picture of retirement security in the United States. The general rule of thumb is that retirees need to replace 70% to 80% of preretirement income in order to maintain their standard of living. Social Security falls far short of that goal, replacing just 40% of preretirement income on average. Forty percent of retirees rely solely on Social Security for income. Given that, it’s no surprise that many are struggling.

The Elder Index, which measures the cost of living for older Americans, showed that the average Social Security benefit covered just 68% of basic living expenses (housing, food, transportation, and healthcare) for a single renter in 2021 and 81% for an older couple.

And the U.S. Census Bureau reported recently that the rate of poverty actually has increased recently among older Americans, despite improvement among all other age groups. The poverty rate among Americans 65 and older rose to 10.3% in 2021 from 8.9% in 2020.

Healthcare costs remain a special source of concern.

HealthView Services, a healthcare data services company serving the financial-services industry, calculates that a 65-year-old with an average Social Security benefit of $31,700 next year can expect healthcare to consume $14,120 of that income. (The calculation is based on national averages and includes premiums for Medicare Part B and D, a Medigap Plan G, dental insurance, and out-of-pocket spending on hospitalization, physicians, and general care.)

And HealthView expects those costs to continue escalating in the years ahead. “One year’s data does not tell the complete story,” said Ron Mastrogiovanni, CEO of HealthView Services. “It is important to look at Medicare and the Social Security Administration’s long-term projections for premium increases and COLAs for retirement planning purposes.”

These adequacy trends are the backbone of arguments for expanding Social Security benefits further. Opponents argue that expansion is unaffordable, yet Social Security expenditures are equivalent to 5% of gross domestic product and are projected to rise to just over 6% in 2040 as the older population rises.

Should we decide to expand benefits, there are plenty of options to pay for it. A partial solution is to increase the cap on wages subject to FICA taxes, which will be $160,200 in 2023. A gradual increase in FICA rates levied on workers and employers would also help fund increases.

An interesting longer-term fix would be to allow the Social Security trustees to invest a portion of the trust fund in equities. By law, Social Security must invest its reserve funds in safe, low-return Treasury securities. Advocates for the idea note that the higher returns offered by equities could be used to ease the burden on taxpayers to fund the program—and even to boost benefits.

Will the Large 2023 COLA Affect Social Security Solvency?

Any reform of Social Security must start with a fix to the program’s current solvency problem. Social Security’s trustees forecast that—f action by Congress—the combined retirement and disability trust funds will be emptied in 2035. At that point, revenue from current tax receipts would be sufficient to cover just 80% of promised benefits. Looked at another way, that is a disastrous across-the-board benefit cut of roughly 20%.

Will the large COLA affect the Social Security solvency forecast? It’s a possibility, but the impact likely won’t be dramatic. In a system as large as Social Security it takes much more than a single large COLA increase to make much of a dent; in 2021 alone, the retirement and disability trust funds collected $1.09 trillion in revenue.

Moreover, when inflation runs high, wage growth also generally accelerates, and that translates into higher FICA receipts that will offset the higher spending, at least to some extent. How much depends on how much of our current inflation is offset by wage growth.

For an article I wrote recently for The New York Times about the COLA, Stephen C. Goss, chief actuary of the Social Security Administration, indicated that the impact of the COLA on the solvency forecast will be small.

Higher Income Replacement Rates

Beyond that, expansion should be on the menu. If the right political consensus develops, we could decide to dramatically boost income replacement rates to anywhere from 80% for low-income workers to 65% for higher earners, as proposed by progressive analysts Nancy Altman and Eric Kingson.

Higher replacement rates will be more important for today’s younger workers than it will be for people close to retirement or already retired. Currently, income replacement levels are falling because of the reforms enacted in 1983, mainly the gradual increase in the full retirement age, or FRA, from 65 to 67, which effectively raises the bar for attaining a full benefit. The FRA is 67 for workers born on or after 1960; that means, for example, that a worker born after 1960 who claims at the earliest eligible age (62) would receive 70% of her full benefit, compared with 80% if the FRA had remained at age 65. The higher FRA is equivalent to an across-the-board benefit cut of roughly 13%. Taxation of benefits—also enacted in 1983—contributes to the lower income replacement rates, too.

The Center for Retirement Research at Boston College calculated how replacement rates will change over time for an average earner who retires at age 65. It concludes that this worker could have expected a 36% income replacement rate in 2015 (after Medicare Part B premiums and income taxes), but only 29% if claiming in 2035.

More targeted expansion ideas also have been proposed, including a more generous COLA, improved benefits for survivors, recognizing unpaid work by caregivers in the benefit formula, reducing taxes on benefits paid by higher-income seniors, and improved benefits for very low income workers. An especially interesting idea would be to reduce the early claiming penalty.

In 1966, 28.5% of Americans aged 65 and older had family incomes below the federal threshold of poverty; by 2019, the poverty rate among seniors had dropped to 8.9%. That’s a stunning public policy achievement that you can credit largely to Social Security and Medicare.

Clearly, Social Security could do more to enhance financial security in retirement. That’s a question of values, not affordability.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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