How Cost-of-Living Index Changes Can Impact Your Retirement - Part 2

By Douglas Carey  DEC 19, 2012 3:45 PM

A decrease in the COLA index will result in a substantial drop in Social Security benefits.

 


A few weeks ago I wrote a fairly popular article that discussed the rising possibility that the federal government will change the cost of living adjustment (COLA) index that Social Security payments are tied to. I wanted to follow up with more information on just how large of an impact this change can have.

Here is a summary of the issue from my previous article:

Currently Social Security payments 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.

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 debate. I want to show how a reduction in the COLA used will impact a person’s retirement situation.

In my previous article I discussed how changes to the COLA index can impact when a person runs out of retirement. Today I want to analyze how this change can impact a person’s annual Social Security payments as well as the lifetime benefits people can expect to accrue.

It is generally believed that the chain-weighted CPI runs about 0.25% below today’s COLA index. I want to show, using our Retirement Planner, what type of impact this will have on a couple’s retirement plan over the years. Let’s start with some assumptions:





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:



Although the decrease of 0.25% in the COLA index might not sound like much, we see that the compounding of this change over time has dramatic results. The cumulative social security benefits that this couple can expect to see 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 dollar terms.

This is a big change for many people and can mean the difference between retiring comfortably or putting off retirement for several years. It is 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 how much their lifetime Social Security benefits will be.

I have also recommended trying to make up for any Social Security shortfall by investing in strong dividend payers throughout retirement. Companies such as Johnson & Johnson (NYSE:JNJ), Coca-Cola (NYSE:KO), Wal-Mart (NYSE:WMT), Exxon (NYSE:XOM), and Procter & Gamble (NYSE:PG) are great additions to a retirement portfolio. I recently wrote a piece on how a company like Procter & Gamble can change your entire retirement situation.

These companies I’ve listed have shown an ability to increase their dividends year after year, even in the face of recessions. By investing in strong dividend payers you can worry less about Social Security because you will be receiving steady income from your dividends all throughout retirement.

Editor's Note: Douglas Carey is a regular contributor to Minyanville's blog.
No positions in stocks mentioned.