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The big day has finally arrived!

Given that Social Security is our country's most successful social program, and that 62% of retired workers are netting at least half of their income from their Social Security benefit, all eyes were on Oct. 10. That's because Oct. 10 is the release date for the U.S. Bureau of Labor Statistics' (BLS) September inflation data, which contains the last puzzle piece needed to calculate Social Security's cost-of-living adjustment (COLA) for 2020.

In simple terms, COLA is the "raise" that beneficiaries receive from one year to the next that takes into account the inflation they've faced. Of course, it's not a raise in the truest sense of the word, because COLA is only designed to keep up with inflation, not outpace it.

Earlier this morning, the BLS reported September's inflation data, allowing for the concrete announcement that Social Security's COLA in 2020 will be rising by 1.6%.

Image source: Getty Images.

Here's how Social Security's COLA was determined

How did the Social Security Administration settle on this figure? I assure you, it wasn't plucked out of thin air, as it was back in the 1950s. Rather, Social Security's COLA is tethered to the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), and has been ever since 1975. The CPI-W has eight major spending categories and a bevy of subcategories, each with their own respective weighting that helps to determine the movement in price of a predetermined basket of goods and services.

Perhaps the most interesting aspect of the COLA calculation is that very few monthly CPI-W readings are actually used. Only readings from the third quarter (July through September) factor into Social Security's COLA. The remaining nine months, while potentially useful in identifying price trends, are not used in the calculation process.

To determine the following year's COLA, the Social Security Administration simply takes the average CPI-W reading from the third quarter of the current year and compares it to the average reading from the third quarter of the previous year. If the average has risen from one year to the next, it implies that inflation has taken place. In such an instance, beneficiaries will receive a "raise" that's commensurate with the year-over-year percentage increase, rounded to the nearest tenth of a percent.

In the rare instance that the reading declines from one year to the next, signaling deflation, benefits remain static. This has only happened on three occasions (2010, 2011, and 2016) since the CPI-W became Social Security's inflationary tether.

Image source: Getty Images.

What does this mean for Social Security beneficiaries?

Now, let's put this calculation into action and see how it's going to impact Social Security's nearly 64 million beneficiaries.

In 2018, the CPI-W's third-quarter readings were as follows:

  • July: 246.155
  • August: 246.336
  • September: 246.565

And in 2019, the CPI-W's third-quarter readings were:

  • July: 250.236
  • August: 250.112
  • September: 250.251

As you can see, the average CPI-W reading in the third quarter of the current year, 250.200, is higher than the average third-quarter CPI-W from the previous year, 246.352. That means beneficiaries will be receiving a boost to their payouts in 2020.

The magnitude of this boost is determined by subtracting the average CPI-W reading in Q3 2018 from the average CPI-W reading in Q3 2019, then dividing the remaining value (3.848 points) into the average CPI-W reading in Q3 2018 to determine the percentage increase, rounded to the nearest 0.1%. That's how the Social Security Administration arrived at a COLA of 1.6% in 2020.

What does this mean for the pocketbooks of Social Security beneficiaries? Based on the fact that the average retired worker and disabled worker were bringing home $1,473 and $1,236, respectively, a month as of August, a COLA of 1.6% should lead to a raise of about $24 a month for retirees and a little under $20 a month for the long-term disabled.

Image source: Getty Images.

Pulling defeat from the jaws of victory

On one hand, it's great news that Social Security beneficiaries are going to receive a meatier monthly payout in 2020. But the cause for celebration is somewhat muted when you consider the fact that COLA has regularly failed to keep up with the actual inflation rates that seniors have been contending with since the start of the century.

According to an analysis by The Senior Citizens League, the purchasing power of Social Security dollars for seniors has fallen by 33% since the beginning of 2000. In simple terms, this means that what retired workers could buy with $100 in Social Security income in 2000 will now buy only $67 worth of those same goods and services.

The problem is that the CPI-W just doesn't do a good job of measuring the costs that matter to retired workers. That's because, as the index's name implies, it's tied to the spending habits of urban and clerical workers, who happen to spend their money very differently than retirees. Thus, the CPI-W ignores the fact that seniors aged 62 and over comprise more than four out of five current program beneficiaries. This leads to an underweighting of truly important expenses, such as medical care and housing, and an overweighting of less important costs to seniors, such as education, apparel, and transportation.

Despite lawmakers from both political parties in Washington agreeing that the CPI-W is flawed, neither has been able to find common ground to fix these issues. As a result, no matter how big or small of a COLA is passed along to Social Security beneficiaries each year, there remains a very good chance that it'll continue to be insufficient to cover the true inflation that senior citizens are actually contending with.

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