Proposed Changes To The COLA Index Could Dramatically Impact Some Clients' Retirement Plans

Friday, January 04, 2013 17:29
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Proposed Changes To The COLA Index Could Dramatically Impact Some Clients' Retirement Plans

Tags: cola index | pensions | retirement planning | social security

A proposal to cut Social Security benefits is being kicked around Congress and gaining  traction. Of course, Congress is not talking about directly cutting Social Security payments. They are talking about changing the cost of living index used to adjust benefits for inflation. The impact of even a fractional change in the inflaton adjustment can materially reduce Social Security benefits and retirement income of some clients.  

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Currently, Social Security benefits increase with the rate of the Cost Of Living Adjustment (COLA) index. The COLA index used for Social Security is equal to the percentage increase in the consumer price index for urban wage earners and clerical workers (CPI-W) for a specific period. This index represents a basket of goods that only changes periodically.

 

However, there is discussion about changing the index used to the “chain-weighted” Consumer Price Index (CPI), which supposedly accounts for substitutions consumers make when prices of certain goods rise. Critics of the proposal, which inlcudes AARP, says the proposal to use chained CPI actually underestimates inflation costs for seniors, who spend more on health care than average Americans. 

 

There are many flaws in the chain-weighted CPI methodology and some believe it is just one more way the government has understated true inflation and pushed more people into higher tax brackets. But the purpose of this article is not to dive into that political debate. I want to show how a reduction in the COLA used will impact a client’s retirement plan.

 

It is generally believed that the chain-weighted CPI runs about .25% below today’s COLA index for social security. Using my Retirement Planner app, here an illustration of the financial impact this would have on a couple’s retirement plan. Let’s start with some assumptions:

 

Inflation (CPI and COLA)

3.00%

Current Age of Both People

50

Age Of Retirement

65

Age When Social Security Is Taken

67

Age When Both People Have Passed Away

95

Social Security at age 65 (combined)

$45,000 per year

 

I ran a scenario to see what happens if the federal government moves the COLA index to the chain-weighted CPI and the COLA index is reduced by 0.25% per year vs. the growth rate in their expenses. In this scenario I assumed their expenses grow by 3% per year and the COLA index grows by 2.75%. I found the following:

Lifetime Cumulative Benefits
Before COLA Change (In Today's $)

Lifetime Cumulative Benefits
After COLA Change (In Today's $)

Difference

$1,296,123

$1,202,033

$94,090

     

Combined Average Annual Social
Security Payments Before COLA Change (In Today's $)

Combined Average Annual Social
Security Payments After COLA Change (In Today's $)

Difference

$45,000

$41,737

$3,263

 

Although the decrease of 0.25% in the COLA index might not sound like much,  the compounding of this change over time has dramatic results.

 

The cumulative Social Security benefits that this couple can expect to receive declines by over $94,000 in today’s dollar terms. Their average annual Social Security benefit will decline by over $3,200 in today’s dollars.

 

This is a big change for many people and can mean the difference between retiring comfortably or putting off retirement for several years.

 

It's best to assume that Social Security benefits will be cut in the future, one way or another. I have recommended for some time now that people should be conservative with their assumptions when it comes to valuing lifetime Social Security benefits. This is one more reason why advisors should warn clients not to expect to receive what was promised.

 

 

 

Comments (4)

...
stvnrsmth
Thanks, Doug. Do you have any idea how much the wage base would have to be increased to raise the equivalent number of dollars, system wide, over the same time period?
stvnrsmth , January 05, 2013
...
douglascarey
Good question. It turns out that this sample couple would need about $4,700 more per year (combined between both people) in after-tax salary income to get them back to where they were before any cuts to COLA.
douglascarey , January 07, 2013
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stvnrsmth
That wasn't my question (which I struggled and failed trying to frame.) My question is: What would the wage cap on FICA taxes have to rise to in order to get to the same solvency result for the system? The present value of the unfunded liability (with a wage cap of $113,000) is $8 trillion, through 2087. Reducing benefits using chained CPI presumably lowers the unfunded liablity by some amount. There is discussion about raising the wage cap to say $200,000. It would be good to know the dollar equivalency of these two proposed methods of saving the system.
stvnrsmth , January 07, 2013
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douglascarey
It's a good question, but is probably best left to somebody else who has done the research on that issue. The only statistic I have to offer is that benefits would have to be cut by 25% across the board, in 20 years, for social security to remain solvent.
douglascarey , January 07, 2013

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