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Here’s how Social Security’s annual COLA gets watered down

by Joseph Arroyo | Contributor
March 1, 2022


Social Security announced big increases in benefits and also big deductions for Medicare payments in 2022. If it’s been a while since you thought about Social Security, now is a great time to not only get up to speed on all that’s happening with retirement payments, but also to review your retirement cash flow results and plans. Reviewing the role of Social Security in your retirement and optimizing your assets to supplement your income will help you make the most out of your golden years.

What was the Social Security COLA for 2022?

For 2022, the cost-of-living adjustment (COLA) for Social Security income was set at 5.9%, the biggest increase in 40 years. The COLA represents an increase in monthly Social Security checks for retirees. The concept of cost-of-living adjustments is designed to help people who would otherwise be on a “fixed income” keep up with the effects of inflation. Inflation would otherwise eat away at a truly fixed income.

The impact of the COLA on Medicare premiums

You’ve no doubt heard about the uproar over the 2022 Medicare Part B premium increase. This monthly premium increased from $148.50 to $170.10, a rise of 14.5%. The $22.10 increase is the largest in the history of the Medicare program.

The Social Security COLA has a big impact on Medicare Part B premiums for one very important reason: By law, the increase in Part B premium cannot be larger (on a dollars per month basis) than the increase in your Social Security check (on a dollars per month basis). It’s a built-in protection to prevent rising Part B premiums from consuming more of your Social Security income than your COLA increase each year. The big jump in COLA for 2022 allowed the Part B premium increase to be unusually large. If the COLA had been smaller, the Part B premium increase would have been limited.

The Part B premium increase was permissible because 5.9% (the COLA increase) of $1,565 (the average monthly Social Security benefit) is more than 14.5% (the Part B increase) of $148.50 (the 2021 Part B premium). In other words, since the premium hike didn’t “eat up” the entire Social Security COLA, the increase was allowed to stand.

However, the Part B increase was still historic and large. It also illustrates a potential problem with the way COLAs are calculated.

The true impact of inflation on a fixed income

For years, people have argued that the way inflation is calculated and used by the federal government undercounts the true increase in the cost of living. Social Security is required to calculate cost-of-living adjustments based on changes in the Consumer Price Index (CPI), or more specifically on a subset of CPI data for wage-earning households. CPI is calculated by the federal Bureau of Labor Statistics (BLS). Although it may sound conspiratorial, many economists and critics believe that the federal government has an incentive to undercount inflation because lower inflation numbers potentially mean that the government owes less money to creditors and Social Security recipients. This happens in two ways:

  • Lower inflation allows for lower interest rates, which reduces the amount of interest the government has to pay on the money it borrows.
  • Lower inflation means smaller COLAs for Social Security and other federal payments.

While the government denies this, there is no disputing that CPI fails to account for many rapidly rising costs. The details are too minute to dive into here, but basically CPI previously measured the price changes of a fixed basket of goods. Over the years, through acts of Congress and other methodological changes, CPI measures the changes in the costs required to maintain a specific standard of living. By doing this, the BLS makes adjustments to the inflation number to account for the fact that if one product increases in price, consumers are likely to buy less of it and more of a different, lower-priced item. BLS and its defenders claim that this better reflects reality, because that is what people do in the real world. BLS critics say that it undercounts inflation by basically ignoring much of the price increases in the basket of goods.

Either way, it is clear that CPI doesn’t take into account the full cost for many types of goods. For instance, the reported CPI for 2021 was 7%. However, the price of unleaded fuel rose more than 45% in 2021. The cost of bacon increased by as much as 13% during 2021. For one more example of staples rising faster than the official inflation rate: Rents for one-bedroom apartments rose more than 20% in 2021.

From these examples you can see that regardless of why CPI is currently calculated the way it is, it seems to miss much of the inflation actually experienced by consumers. This of course, really is a problem for those on fixed incomes like retirees. If these kinds of price increases continue to outpace Social Security COLAs, then actual purchasing power will be severely diminished in only a few short years. It will behoove current and soon-to-be-retirees to make plans to deal with these rising costs.

How to handle rising inflation

Regardless of whether the government calculated CPI is accurate or not, or whether it is purposefully understated, it’s important to have a plan for combatting inflation. Even inflation that is considered to be “mild” will eat away at your standard of living during the course of your retirement. You can attempt to accomplish this task through one or a combination of these methods:

  • Accumulating a bigger nest egg before you retire.
  • Owning assets that earn more than the rate of inflation.
  • Reducing your living expenses (downsize) during retirement to make your income stretch as far as possible.

We’ll review each of these aspects and suggest some courses of action for each of them.

Downsizing in retirement

While downsizing has a negative connotation, it can be a very useful tool to make your retirement dollars stretch further. Certainly, nobody wants to have to be a penny-pinching miser, but there are a number of ways you can trim your expenses without impacting your lifestyle.

For starters, you might want to consider relocating to a lower-cost state. Many people retire to warmer climates in the southern half of the country, and for a number of reasons. Not only do these states tend to have milder winters, the cost of living is generally lower there. For many people, this would allow them to sell a home they own in a higher-cost state, generally for much more than they paid for it, and purchase a much more affordable home. You might still have a large gain after the purchase of your new home that can be invested or used for boosting your income.

In conjunction with relocating, you can consider getting rid of vehicles you don’t need, especially if you owe money on them. Paying off the balance of any cars you need or want to keep will also free up cash flow. The same goes for paying off credit cards or other non-productive debt.

Another option would be to move to another country, one known to be a haven for American retirees. Many dream of moving to the tropics for retirement, but thousands of Americans have successfully retired in coastal Mexico, Belize, Costa Rica or other countries that are relatively near to the United States. Your fixed income is likely to go much further there than here.

Accumulating a bigger nest egg before you retire

Having a larger nest egg will help your retirement in all sorts of ways. A big nest egg will enable you to retire in the United States and handle any ill effects of inflation. Or, if you move to another country, your standard of living will be even higher. How do you do this?

An older man showing his significant other a document with a grin on his face

The obvious answer is that you need to save more and earn more and higher interest, dividends and capital gains. While this is true, one of the most effective ways to have a larger nest egg is to lose less money than other people. For instance, if you had been able to avoid all the down years on the S&P 500 from 1926 to 2014, $1 would have grown to over $53,000. But, if you were fully invested in the index every year, including down years, your $1 only grew to $5,300. This difference is absolutely huge. While it’s probably humanly impossible to predict which years are going to be down years, it highlights how big a deal limiting losses is.

We all know that the stock market has losing streaks. Mostly these are fairly mild, but the market does occasionally blow up with major losses. These can be terrifying and also devastating to your portfolio. One way to avoid these kinds of losses, while also earning a compelling rate of return, is through the use of indexed insurance products like fixed index annuities (FIA) or indexed universal life insurance (IUL).

With these insurance products, your interest rate is tied to the performance of one or more financial indexes. The rate of return of the index determines the interest rate your money earns. There are several policy-specific variables like the participation rate and cap rate, which determine how much of index rate of return ties in to your interest rate – but the potential exists to earn a much higher interest rate than is available on traditional insurance or annuities. The best feature of these indexed products is that they provide strong protection from market losses. In fact, the worst you can do is earn 0% on your money. If the market index is down for the year, you’re protected from actually losing money; you simply don’t earn any interest. While earning 0% doesn’t sound great, remember how important it is to not lose money. It’s much better to never lose money and make steady gains than to make big gains, but also make losses.

By making steady gains and avoiding losses, you’ll be able to build a larger nest egg. This bigger nest egg can allow you to earn more income from your portfolio. This portfolio income will supplement your pension, if you have one, and your Social Security income, which translates to better inflation protection.

Own assets that earn more than the rate of inflation

This is a simple concept; if inflation is a problem, just make sure that you earn a higher rate of return on your portfolio than the inflation rate. Of course, you probably realize that this isn’t always practical. For one thing, “true inflation” may be much higher than the reported number, and trying to make gains that large could expose you to major risks.

That is the crux of the problem for retirees. In order to earn the kinds of interest needed, you have to be invested in riskier assets than you’d like. This is known as “reaching for yield” and it is a major problem for savers and retirees. Traditionally, the safe play was to have most of your portfolio invested in government bonds, AAA-rated corporate bonds and dividend-paying blue-chip stocks. These investments used to pay enough income to help fund an ample retirement lifestyle. Unfortunately, those days seem to be long gone.

The main culprit is historically low interest rates. In response to the Federal Reserve’s maneuvers during the financial crises of 2008 and 2020, interest rates plummeted. Interest payments on even long duration government bonds have remained significantly lower than they were before 2008. In short, it’s impossible to earn a high enough rate of interest to live off of interest income – not without reaching for yield, anyway. This temptation must be resisted. As we saw before, losses impact portfolios more than spectacular gains. Experiencing big losses while you’re already in retirement is not a scenario you want to experience.

So, what can you do? What kind of assets pay higher income than traditional bond portfolios while still remaining safe? You may want to consider allocating some of your portfolio to:

  • Real estate assets – either rental properties or REIT-type investments that charge rents based on real-world inflation rates.
  • Precious metals – gold is historically known as a good inflation hedge. You don’t want to go crazy here, but having some exposure to gold could help you keep up with inflation.
  • Indexed annuities and life insurance policies.

Indexed insurance products can remain a part of your portfolio even in retirement if you’ve made a solid plan for managing your cash flow. Money that won’t be needed for many years can grow at better-than-market interest rates and yet be protected from market losses, which is a good combination for a retirement portfolio.

Make and stick to a plan

Knowing about the dangers of inflation is half the battle. You know that Social Security COLAs aren’t going to allow you to maintain the lifestyle you want in retirement. You have to have a strategy to deal with this. A great way to do this is to work with financial professional. A financial professional who knows you’re worried about inflation can help you find the right investments to meet your goals and needs.

After you’ve developed a retirement income plan, make sure you stick to it. Spend within the parameters you’ve developed, and make sure to keep saving as large a percentage of your income as possible before your retirement.

As years pass, make sure to keep meeting with your financial professional to see how your plan is performing. By meeting regularly with them, you can make any changes necessary to keep your retirement a time of enjoyment and happiness.

Alliance America can help

Alliance America is an insurance and financial services company dedicated to the art of personal financial planning. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.

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