Social Security COLA Doesn't Match Inflation

Last week's annual trustees' report on the financial health of Social Security showed the program did not suffer serious erosion during the past year. Current Social Security resources are sufficient to pay all benefits for the next 27 years. That's hardly the self-sustaining funding model that we'd like to see but it's good news nonetheless. However, it won't stop efforts to "fix" the program. And it won't halt the discussion over the adequacy of the annual cost of living adjustment (COLA) with which Social Security tries to keep retirees' benefits from being eroded by inflation.

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Low rates of inflation in the year ended last fall caused the COLA to be zero for the first time in the 25-year history of these annual adjustments. Recipients received a one-time $250 payment, which helped compensate for that and was also pitched as an economic stimulus program.

Now, we're coming up on a second year with little if any inflation, as measured by a version of the Consumer Price Index used to determine the Social Security COLA. The index measures price changes for working people. Legislation has been introduced for another $250 payment, and AARP and other groups are lobbying for its approval.

However, the fiscal picture is much darker than it was even a year ago. And while Social Security's finances may have held up, the same is not true of the government's budget. We are awash in red ink with no end in sight to deficits. With mid-term elections this fall, just about everyone has found religion when it comes to government spending. So, the argument for another round of make-good Social Security payments is a tougher sell in 2010 than it was last year.

However, according to a recent academic study, the fairness of such a payment is beyond dispute. The study reviewed Social Security payments over many years, backed out spending on basic Medicare premiums (for part B physician and outpatient services) and other out-of-pocket medical spending, and then compared the remaining amounts with money that recipients paid for other goods. Researchers studied a group of older retirees who turned 65 in 1983 (the year the COLA began), and a second group of persons born in 1928. The authors -- Gopi Shan Goda and John B. Shoven at Stanford and Sita Nataraj Slavov at Occidental College -- found the value of recipients' benefits for non-healthcare spending had eroded by about 20 percent for men and nearly 27 percent for women. Those are big cuts: one out of every five dollars in benefits is effectively gone for men; one of every four dollars for women.

And their findings probably understate the actual ground lost, because the study did not include the cost of other health insurance premiums when considering out-of-pocket healthcare spending. Besides Part B premiums, other insurance includes Medicare Supplement, Medicare Advantage, Part D prescription drug coverage, and other private coverages. To the extent that the rise in premiums for such insurance has exceeded the overall rate of inflation, the study's findings would need to be adjusted to show further erosion in the effective non-medical buying power of Social Security benefits. And by all accounts, health insurance price inflation has far outpaced the rise in overall prices.

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"Of course, these results assume no other income besides Social Security," the researchers say, "but a sizable fraction of the elderly depend on Social Security for the majority of their income: 64 percent of beneficiaries rely on Social Security for 50 percent or more of their income, and 35 percent of beneficiaries rely on Social Security for 90 percent or more of their income."

Even if funds were available, fixing this situation is no easy matter. This is because there are two root causes for how healthcare expenses erode the true value of Social Security benefits. The first is the rate of inflation for such expenses. The second is the fact that people simply use more healthcare as they age. "Even if medical costs did not rise faster than the prices of other goods," the study says, "as retirees aged, their medical spending would still tend to increase as a share of income."

There is an experimental government price index called CPI-E that is designed to measure the actual spending of retirees. It thus includes more weighting for medical costs. "The CPI-E has increased faster than the CPI-W over the past 20 years," the study says, "due primarily to the relative rise in health costs, and the fact that the elderly spend more on health care than the non-elderly, even after taking into account the availability of Medicare." Using the CPI-E to determine the annual COLAs for the study's subjects would have narrowed the gap, with men falling only 11 short of maintaining their effective buying power for non-medical items, and women falling 18 percent short.

But the financial consequences of even this seemingly simply shift are huge. Remember that 27-year estimate for Social Security sufficiency? According to one study, using the CPI-E to set annual COLAs would slice five years from that cushion all by itself. Further, like all measures of price change, the CPI-E does not even try to factor in changes in product quality. The $1,000 television set you buy today is vastly superior to the $1,000 set you could have bought 20 years ago. Such qualitative improvements have been enormous in healthcare.

With all the talk about changing Social Security, it would seem to make great common sense to take a careful look at the COLA mechanism. What good is it to put the program on a sound 75-year trajectory again if the interests of seniors aren't appropriately considered and protected in the process?

[See Social Security and Senior Financial Abuse.]