Want to understand how the COLA is calculated? It’s complicated. Read on …

By David Enna, Tipswatch.com

With the release of the June inflation report on Wednesday, we now have a pretty good idea of where the Social Security cost-of-living adjustment will be heading for payments in 2023, beginning with benefits received in January.

Inflation trends through June make it look likely that next year’s COLA could fall into a range of 9.6% to 10.3% for 2023, the highest increase since an 11.2% bump in 1981. But if inflation continues at its current torrid pace, the COLA could be even higher.

The Social Security Administration’s COLA formula is ridiculously complex and little understood. Is it related to U.S. inflation? Yes, but not the inflation index you hear about each month. Does it reflect 12 months of U.S. inflation? Not really. Does it underestimate actual U.S. inflation? Sometimes, but not always.

Annual U.S. inflation (measured by CPI-U) is running at 9.1% as of June, but the Social Security Administration doesn’t use CPI-U. Instead, it uses the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). For that index, the June annual increase was actually higher, at 9.8%.

The Senior Citizens League, a credible advocacy group, is projecting that the 2023 COLA could be 10.5%, and I think that is possible, but also might be just a tad too high. Why the uncertainty? The SSA’s complex formula makes predictions extremely iffy and airtight accuracy is impossible. Let’s take a look at how the COLA comes together …

The Index

CPI-W includes data only from households with at least 50% of income coming from clerical or wage-paying jobs. I’ve noted in the past that CPI-W generally lags slightly behind CPI-U, which means the Social Security COLA also generally lags behind the standard measure of U.S. inflation. However, this year — and also last year — it has running higher than official inflation.

CPI-W isn’t widely tracked or reported, but the Bureau of Labor Statistics updates the index each month in its overall inflation report. Right now, you could say, “Well, CPI-W is running at an annual rate of 9.8%, so that will likely be the COLA increase for 2023.” But that’s not true. In fact, the June number isn’t necessarily an accurate indicator, as shown in this chart:

June sets the baseline for the COLA increase, but then we come to …

The Formula

The SSA doesn’t look at a full year’s data to determine the COLA. Instead it uses the average CPI-W index for the third quarter — July, August and September. Here is the definition from the SSA site, in typical crystal-clear language of government bureaucrats:

A COLA effective for December of the current year is equal to the percentage increase (if any) in the average CPI-W for the third quarter of the current year over the average for the third quarter of the last year in which a COLA became effective. If there is an increase, it must be rounded to the nearest tenth of one percent. If there is no increase, or if the rounded increase is zero, there is no COLA.

The translation: This wording means that the SSA eliminates years where inflation was zero or negative, and so there isn’t a “bounce-up” effect on benefits after a year of deflation. Instead, it goes back to the last year where there was an increase in benefits. But that won’t matter in this 2023 calculation, because the COLA rose 5.9% this year.

So, although 12-month CPI-W was up 9.8% in June, that number is only the baseline for the 2023 COLA increase. The only inflation numbers that will matter are for the third quarter: July, August and September. Last year, the CPI-W index averaged 268.421 in the third quarter. The June 2022 index was set at 292.542, which is 9.0% higher than the 3rd quarter average in 2021. So if we have zero inflation in July, August and September, the Social Security COLA will be set at 9.0%.

U.S. inflation can be stubbornly finicky in the summer months, so predicting inflation from July to September is an impossible task. Hurricanes, gas shortages, food crop failures, stock market plunges, outbreaks of war, supply shortages, pandemic resurgence, etc., etc. It’s a guessing game, and nearly every summer brings some surprises.

Plus … the U.S. economy could potentially be slowing, which could at least tame our current raging inflation, a bit.

Projecting the 2022 COLA

At this point, CPI-W is running at 9.8% over the last year, so maybe you’d expect a continued inflationary trend of nearly 0.8% through the summer months? It could happen. I don’t think it will, however. The Cleveland Fed is currently projecting an all-items inflation rate of 0.39% for July, which I’m sure is influenced by the recent decline in gas prices.

If gas prices continue slipping lower this summer — and that’s a big if, I know — then inflation should begin moderating, while staying at very high level. Could inflation run at 0.0% for three months? Doesn’t seem likely. But what about 0.4% or 0.5% a month? That seems possible. Plus, we could see an oddball month, surprisingly higher or lower. It happens almost every summer.

Let’s take a look at how differences in 3rd-quarter inflation would alter the 2023 COLA:

Where is inflation heading this summer? I really don’t know. I can tell you that last year — when inflation was beginning to percolate — CPI-W rose from 266.412 in June to 269.086 in September, an increase of 1.0%. But that 1% increase was front-loaded into a 0.52% increase in July, followed by relatively tame increases of 0.22% in August and 0.26% in September.

Inflation is hard to predict

Yeah, but I write about inflation, so why not take a stab? My thinking is that inflation is likely to average 0.3% to 0.6% a month from July to September, and that would put the Social Security COLA in a range of 9.6% to 10.3%. If current inflationary trends continue, I’ll probably end up on the low side.

So let’s nail this down to a prediction of 9.9% to 10.1%. (But I’m queasy about this.)

In 2021, I predicted a COLA increase of 6.0% “looks likely.” Correct answer: 5.9%.

In 2020, I predicted “a number very close to zero,” Correct answer: 1.3%.

In 2019, I predicted “a range of 1.6% to 1.8%.” Correct answer: 1.6%.

In 2018, I predicted a range of 3.1% to 3.2%. Correct answer: 2.8%.

In 2017, I predicted the COLA was likely to be “less than 2.2%.” Correct answer: 2.0%

So there you go, that’s my track record. The point is: You will be seeing lots of media reports in coming weeks about the Social Security COLA soaring to 10% or higher. But no one truly knows. Three months of data are needed. At least now you can understand how those predictions were made, and the complex formula that underlies the whole thing.

What this all means

For 2022, the Social Security Administration says, the average monthly benefit for retired workers is $1,666, so a 10% increase would boost that benefit to $1,833, beginning in January. If you are in the Social Security “limbo” period — older than 62 but not yet taking benefits — your future benefits would also climb by this percentage.

However, recipients can also expect that Medicare Part B costs could rise in 2023, which will subtract — at least partly — from the higher benefits. But this is a foggy issue, because the SSA pushed Part B charges 14.6% higher for 2022 because of potential approval of the Alzheimer’s drug, Aduhelm. Since then, the costs of that drug have declined, and it is not being widely used. That could mean Part B charges won’t increase greatly in 2023, or possibly even decline.

We won’t know the actual COLA number until 8:30 a.m. EDT on October 13, 2022, when the Bureau of Labor Statistics releases the September inflation report and completes the data needed for the 3rd quarter average of CPI-W. I will be tracking these numbers for July, August and September as each inflation report is issued.

I keep a running total of the CPI-W changes on my Social Security COLA page.

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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.