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How Inflation Affects Social Security Benefits

With inflation a top concern among Americans these days, you may be wondering how Social Security’s cost-of-living adjustment is calculated.

With inflation dominating the news, you may be developing more than a passing interest in how the Social Security cost-of-living adjustment (COLA) is figured. Whether it’s a matter of simple curiosity or an effort to maximize benefits through strategic claiming, you should know how Social Security benefits are adjusted for inflation—both before and after retirement.

Social Security is one of the few sources of predictable, inflation-adjusted lifetime income available to retirees. This, by itself, is a reason to maximize benefits through strategic claiming. Compared to the task of repositioning investment portfolios for an inflationary environment, maximizing one’s inflation-adjusted Social Security benefit is easy—just claim at the optimal age and let Social Security’s automatic inflation adjustments raise the income each year at a rate that approximates rising prices (though on a lagging basis and not necessarily matching a recipient’s own spending experience).

Before I get into how it all works, we must acknowledge that some clients have a misguided notion of the optimal claiming strategy about the COLA. More than a few people have asked if they should claim their benefit early to get the COLA. The answer is a resounding, “No!”

All PIAs (Primary Insurance Amounts) are raised with the COLA, whether benefits have been claimed or not. In fact, the optimal claiming strategy regarding the COLA is to claim at an age that will provide the highest possible benefit—age 70 for retirement benefits and FRA (Full Retirement Age) for spousal benefits—because that will maximize the dollar amount of the COLA.

It’s simple math: A client with a PIA of $3,000 and FRA of 67 will receive $2,100 if he claims at 62 versus $3,720 if he claims at 70. This year’s COLA of 5.9% would have given the early claimant a monthly increase of $123.90, versus $219.48 for the later claimant.

The COLA is based on the Consumer Price Index (CPI), which measures price increases of goods and services from year to year. The CPI usually makes the headlines when it’s announced each month, especially this year, when inflation is running higher than normal due to a myriad of factors.

Some argue that the CPI-W is not a good index for the Social Security COLA because it measures spending by urban wage earners, not retirees. It also doesn’t consider changes in buying habits when inflation is high—substituting chicken for steak, for example, when there’s a spike in beef prices. At various times people have claimed that the CPI-E, which measures spending by the elderly, or the “chained” C-CPI-U, which takes buying substitutions into account, should be used instead. But in the end, it doesn’t make much of a difference. There have been years where the CPI-E would have provided a lower COLA than the CPI-W and the C-CPI-U would have provided a higher COLA. So, it all likely evens out over the longer term.

If you want to know exactly how the COLA is applied to your Social Security benefit, you can go to the web page of SSA Office of the Chief Actuary. Here it explains that the COLA for 2022 equals the percentage increase in the CPI-W from the third quarter of 2020 through the third quarter of 2021. In figuring the COLA, SSA uses the raw index, which stood at 100 in 1982–84. It averages the index for July, August, and September of 2020 and 2021 respectively, subtracts the 2020 average from the 2021 average, and figures the percentage gain. That difference was 5.9%.

So, in December 2021, SSA’s automated system raised the PIA of everyone age 62 or older by 5.9%. For those who had already claimed their benefit, the system then applied the appropriate reductions or credits for early or delayed claiming and adjusted January checks accordingly. (This has the effect of simply raising everyone’s checks by 5.9%, but the fact that the COLA was applied to the PIA, after which reductions or credits are applied, is important for understanding that all PIAs are raised by the COLA, whether benefits have started.) For those who had not yet claimed, the PIA was raised by 5.9%; the reductions or credits will be applied at the time of claiming. Auxiliary benefits such as spousal, survivor or dependent benefits are also adjusted as the PIA on which they are based is adjusted.

Some people are trying to get a jump on the 2023 COLA by checking the inflation rate over the past 12 months and extrapolating it out. According to the latest release, the CPI-W in May was 9.3% higher than a year ago, suggesting a rather large COLA for 2023. Those who want to be a bit more precise can compare the raw index in May (288.022) to the third quarter average in 2021 (268.421) which would result in a possible COLA of 7.3%. But there are four months to go before the COLA will be calculated, and a lot can happen between now and then—even a possible decline from May’s index if prices revert to more normal levels.

Inflation adjustments for current workers

To understand how Social Security benefits keep up with inflation for people who are still working, it is necessary to understand how the benefit is calculated and how some of the components in the formula are adjusted for inflation.

The PIA is calculated for each person the year they turn 62. In calculating the PIA, SSA tallies up all earnings through age 61, indexes each year’s earnings for inflation (except earnings for ages 60 and 61, which are recorded at nominal value), averages the highest 35 years of earnings to get the AIME (Average Indexed Monthly Earnings), segments the AIME into three tiers based on that year’s bend points, multiplies each tier by a set percentage—.90, .32 and .15—and then totals these dollar amounts to get the PIA.

The PIA is the benefit the person will receive if it is claimed at full retirement age (FRA). If claimed before or after FRA, the benefit will be reduced or increased as shown in this table. https://www.ssa.gov/oact/ProgData/ar_drc.html Once the PIA is calculated, it is adjusted each year for the COLA as described above.

A maximum earner born in 1960, whose PIA is calculated in 2022, has a PIA of $3,357.50. The PIA is the amount they’ll receive if they claim benefits at their FRA. But by the time they get to FRA, in five years, the PIA will have been adjusted for inflation, so the amount they receive will be higher. If they wait until age 70 to claim, they’ll get three additional years of COLAs (compounded) plus delayed credits of 8% a year (not compounded), giving them the highest possible benefit.

Inflation adjustments for current workers happen in the indexing factors and bend points, which rise each year based on increases in the national average wage index (AWI). Workers under 62 can be assured that by the time their PIA is calculated, the indexing factors and bend points will be higher than they are today, resulting in a higher Social Security benefit. To put it simply, benefits rise with wages while people are earning (before age 60) and with prices while they are spending (after age 62).

The wage index is a lagging indicator. Whereas the COLA is based on the prior year’s CPI (third quarter to third quarter), the indexing factors and bend points are based on the AWI two years prior. This can cause a bit of a disconnect. Usually the AWI exceeds the CPI, but in 2020—the index used in calculating PIAs for 62-year-olds in 2022—it didn’t. The 2020 AWI rose just 2.83% over the 2019 index, compared to the 5.9% COLA.

This can cause some inequities among cohorts. This year’s 62-year-olds (the 1960 cohort) didn’t get the COLA because their PIAs were only just calculated this year—and their indexing factors and bend points were based on a lower-than-usual increase in the AWI. Next year, the 1960 cohort will get the (presumably high) COLA along with everyone else over age 62, but the 1961 cohort, who will be having their PIA calculated in 2023, will not. Their increase will depend on the amount by which the 2021 AWI exceeds the 2020 AWI of $55,628.60. Wage statistics are not as easy to track as the CPI, so there’s really no telling what the 2021 AWI increase will be or what those indexing factors and bend points will turn out to be.

As you can see, adjusting Social Security for inflation is exceedingly complex. It may not be perfect, but it’s not bad. Social Security does a better job than most sources of retirement income in helping retirees keep up with the rising cost of living.

If you have any questions about Social Security Benefits, please send your question(s) and contact information to LRobinson@CapSouthPartners.com.

P. Lewis Robinson, CPA – Managing Director/Senior Wealth Advisor

1.Source: How Social Security Benefits Keep Up With Inflation, July 8, 2022, By Elaine Floyd, CFP®

To discuss this article further or to learn more about CapSouth Wealth Management, visit our website at www.capsouthwm.com or call 800.929.1001 to schedule an appointment to speak with an advisor.

Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice. Any performance data quoted represents past performance; past performance is no guarantee of future results.

Inflation

Fighting Rising Inflation

Four Ways to Protect Your Financial Life: Everywhere we turn right now, it seems we are spending more. I notice it most at the gas pump and at the grocery store, but for savvy shoppers, I bet you’ve noticed that almost all the items you purchase regularly are creeping up in price. Chances are you can’t make it through the day without seeing or hearing a story about the dreaded 9 letter word – inflation.  For a while, we heard the term “transitory inflation” which meant it was supposed to be temporary. Not since the late 1970s and early 80s has the U.S. seen the inflation rates we are currently experiencing which means anyone under the age of 50 has little experience on protecting their financial life during periods of rising inflation. 

What exactly is inflation? Webster’s dictionary defines inflation as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services”. We could debate until we are blue in the face on the “how we got here” portion of the definition.  So instead, let’s focus on the first part of the definition, “a continuing rise in the general price level.” Our dollars aren’t going to buy as much as they once did because things cost more. Our cash flow can get tighter even if we take steps to cut down on discretionary spending. The U.S. Bureau of Labor Statistics utilizes the Consumer Price Index (CPI) to measure the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. On May 11, 2022, the U.S Bureau of Labor Statistics released their most recent numbers and reported that over the last 12 months, the all-items index increased 8.3 percent before seasonal adjustment. So, when faced with rising inflation, what are a few basic steps we can do to protect our financial life?

Brush Up on Your Budget: The first way to protect your financial life during rising inflation is to utilize a budget. Whether you are an avid user of a budget or absolutely hate the thought of building a budget, it’s time to pay closer attention to the dollars we are spending. What areas of your cash flow aren’t discretionary? Are they impacted by inflation? Fixed interest rate payments such as mortgages aren’t impacted. However, variable debt payments often aren’t discretionary, and they can be impacted by inflation. As the Fed raises interest rates to combat rising inflation, your variable payments are likely to increase as well. Feeding your family isn’t discretionary. Whether it’s cooking at home or eating out, the cost of feeding them has gone up.  Prioritize the non-discretionary items in your budget first.  Then take an inventory of the discretionary areas of your remaining cash flow.  It stands to reason that almost every item is impacted by inflation.  Travel and home renovation projects are two key areas to review.  Can you shave off some costs? Can you postpone the project or trip? We put a long-planned deck remodel on hold for now due to the rapidly rising costs of building materials because it was something we wanted but not something we absolutely had to have right now. However, we prioritized travel because it’s important to us, and we’ve budgeted more than normal for items like air fare, rental car gas and eating out. It’s important to acknowledge that trade-offs may be necessary. Employers aren’t raising wages at the same rate of inflation, and if you are retired, your sources of retirement income are also impacted by inflation.  

Seek Out Savings After you’ve checked your budget and reprioritized as needed, it’s time to go on the hunt for savings in order to fight inflation. Consider changing up your normal grocery shopping routine to find the best deals. Buying in bulk at wholesale clubs, while potentially more expensive upfront, can save you money over the long term. For our family, we used to shop at a local grocery store and then would fill in the gaps at Costco. Now we have completely flipped our buying habits. We can get fruits and veggies either in double the quantity for the same price or less at Costco, so we start there and then buy smaller perishable items at the local grocery store. Our local grocery store also has a program called Fuel Points which allows us to save money when filling up our vehicles. Sometimes this is even more advantageous than buying gas at a wholesale club. 

Rising inflation can also impact your monthly energy bills.  Recently on social media platforms, published summer recommendations for air conditioning from the U.S. Department of Energy began to circulate. They suggest that the thermostat be set to 82 F when sleeping and 85 F when out of the house for maximum savings. The backlash was swift and most of the commentators stated they would never be comfortable. As a woman who grew up in Georgia, I can’t even fathom trying to sleep in a house set at 82! Even if you don’t agree with the recommendation, you can be mindful of settings and usage. A smart thermostat such as Ecobee or Nest can do much of the work for you by allowing you to input routine settings and detecting if no one is home and adjusting the temperature appropriately. 

Another area to shop for savings impacts the cash you may hold. Rising interest rates may have negatively impacted areas of your financial life, but one area where they are having a positive impact is the savings rates. CDs and Money Market funds are on the rise, and it’s time to review. While these rates aren’t likely to keep up with rising inflation, they can help close the gap for the cash in your portfolio. 

Conduct an Insurance Review Do you own a home, car, boat or other recreational vehicle? I bet you answered yes to at least one of these so it’s time to conduct an insurance review.  When was the last time you checked your Homeowner’s policy for your home’s replacement value? If you are like me, it has been too long.  We are keenly aware that the cost of buying a home, or a car is on the rise, but if you aren’t in the market to buy a home or car you may think you aren’t impacted. What would happen though if your home sustained fire or wind damage? What would happen if your car was totaled? For example, let’s consider you have a home that you purchased 8 years ago for $500,000. At the time the cost to replace that home may have been similar to the purchase price. However, with some building materials costing 300% more than they did two years ago, $500,000 could be well short of what it would take to build your exact home now. While we may not think a tragedy would happen to us, they do occur, and you need to consider the financial implications. 

The cost to repair or replace the large ticket items has gone up, and it can be complex when the item is typically considered a depreciating asset. Cars, boats and RVs are examples of depreciating assets that require financial consideration particularly if you have an outstanding loan balance. No one wants to be “upside down” (where you owe more than the item is worth) on a loan. Rising inflation and supply chain issues make this a real possibility. Review your insurance policies to verify your coverages, particularly your replacement cost coverage. Won’t my insurance rates go up you may ask? They may. You must determine if you are willing to handle the risk of not paying the increased premium. Could you absorb the cost difference to replace or rebuild an asset if there is a shortfall? There is no “one size fits all” answer here so consider your personal financial situation and risk tolerance. 

Invest for the Long Term The fourth way to fight rising inflation is to review your investment allocation. Historically, the equity market outpaces inflation.  I recognize that the recent decline and volatility of the equity market has many nervous, and if that’s you, please know that CapSouth’s advisors understand how you are feeling and will not be dismissive. Investing overall right now can seem daunting. Rising interest rates are impacting a portion of the bond market negatively. The equity market is bouncing all over the place and terms like “cash is trash” are being used by television news pundits.  Nothing feels “safe”. So, we turn to the past to learn how to manage for the future. 

If you are still working with a long-time horizon, you may consider increasing contributions to your retirement savings via your workplace retirement plan (if you are not already maxing out) or via a taxable investment account if you have the discretionary income to do so.  In a recent CNBC article [https://www.cnbc.com/2022/03/22/why-high-inflation-makes-investing-in-the-stock-market-a-smart-move-.html], Ed Slott, a nationally recognized IRA distribution expert, professional speaker, television personality, and best-selling author, was quoted as saying, “If you keep contributing to your retirement savings, you’ll always have more,” He also recommended additional investment strategies such as dollar-cost averaging which he said, “smooths out your contributions over time, so the impact of volatility is much less.” 

If you are no longer contributing to your investment assets due to retirement or other reasons, it’s still wise to reevaluate your holdings and your risk tolerance.  Were you overly aggressive when the market was on its historic march up and perhaps underestimated how you would feel in a down market? It’s okay if you answered yes, and you wouldn’t be the only one.  It’s important that you share how you are feeling with your advisor so they can help navigate both your financial and emotional wellbeing. Diversifying and rebalancing are additional strategies your CapSouth advisor may utilize to help round out your portfolio to fight rising inflation. 

Final Thoughts on Fighting Inflation Fighting rising inflation has become top of mind for many of us. We can’t seem to get away from the impacts of rising inflation or the stories about it. As a former journalism student who worked at a major television station in college, some of the best advice I can give you is this – tune out the noise. This may mean turning off the television or radio channel. Perhaps it means taking a break from social media when things get to be overwhelming.  Try to remember that periods of sustained inflation have been rare for the U.S. Instead of focusing on the news or trying to figure out things on your own, it may be time to engage with a financial advisor if you have never done so. CapSouth advisors are well equipped to discuss your personal inflation impact and to help you adjust accordingly. They will apply financial planning techniques to your specific situation which will ultimately be more beneficial to you than trying to listen to media personas or trying to figure it out yourself. We take great pride in being the voice of reason and calm in a sea of chaos.  We always have your best interest in mind, and that extends to helping you fight inflation as well. If rising inflation is adding anxiety to your financial life, we’d love to help. 

To discuss this article further or to learn more about CapSouth Wealth Management, visit our website at www.capsouthwm.com or call 800.929.1001 to schedule an appointment to speak with an advisor.

By: Jennifer Fensley, CFP®, CRPS® | Wealth Advisor

Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice. Any performance data quoted represents past performance; past performance is no guarantee of future results. This article contains external links to third party content (content hosted on sites unaffiliated with CapSouth Partners). CapSouth makes no representations whatsoever regarding any third party content/sites that are accessible in this article. Linking to these third-party sites in no way implies an endorsement or affiliation of any kind between CapSouth and any third party, including legal authorization to use any trademark, trade name, logo, or copyrighted materials belonging to either entity.

Refunds to the Highly Compensated

Refunds to the highly compensated employees (HCE) in a qualified retirement plan can be frustrating to the participants and a challenge to the plan administrator.  Various options exist to improve this situation.  These include:

  • More effectively manage the deferral and refund process
  • Eliminate the issue of refunds caused by testing
  • Allow the participant to continue to individual retirement accounts

This article will discuss these options.

  1. More Effective Management 

If a plan is using the “current year” testing method, consideration could be given to using “prior year” testing.  Under the “current year” option, the data is not finalized until after the end of the year and the HCEs do not know the amount they can contribute until after the testing is completed.

Under the “prior year” option, the data from the previous year is used to provide the maximum deferral amount for each HCE.  This should eliminate excess deferrals that require refunds.

Another option is to notify the HCE at the beginning of the year regarding the estimated maximum deferral.  This is based on the prior year average deferral of the non-highly compensated employees (NHCE) and a review of the current deferrals of each of the HCE.  Of course, this amount may change during the year due to changes in the deferrals of either group.

  1. Consider a Safe Harbor Plan

A safe harbor plan allows the HCE to contribute the maximum allowable deferrals without regard to the average deferrals of the NHCE. There are various safe harbor options that a plan could consider.  These include:

  • Basic Safe Harbor Match (equal to 100% of amount contributed up to 3% of pay, plus 50% of amount contributed, up to the next 2% of pay);
  • Enhanced Safe Harbor Match (must be at least as generous as the basic formula, normally equal to 100% of amount contributed up to 4% of pay);
  • 3% Non-Elective Contribution (NEC); and
  • Qualified Automatic Contribution Arrangement (QACA):
    • QACA Match (equal to 100% of amount contributed up to 1% of pay, plus 50% of amount contributed, up to the next 5% of pay) or
    • QACA 3% NEC.
  1. Options for the Participant

Each HCE has several options to contribute to retirement accounts outside of the qualified plan.  These include:

  • IRA Deductible Contributions:  In most cases, HCEs do not qualify to make deductible IRA contributions.
  • Non-Deductible IRA Contributions:  Most HCEs qualify to make non-deductible IRA contributions.  The maximum contributions to IRA accounts for 2022 is $6,000 plus $1,000 for employees 50 and older. 
  • IRA to Roth IRA Conversions:  Each HCE should carefully consider the strategy of making non-deductible IRA contributions followed by a Roth conversion.  This works extremely well with participants who do not have an existing IRA account.  The non-deductible contribution is made, and the account is immediately converted to a Roth IRA.  The result of this process is that the money ends up in a Roth IRA growing income tax free just as it would have if the HCE elected to defer to the Roth 401(k) account inside the qualified plan.  If the participant has existing IRA accounts with zero basis, this option does not work as well.  In this case, the conversion would create additional taxable income.  This may or may not be an issue based on the current tax bracket and the projected future tax brackets. 
  • Some HCEs have outside businesses that generate taxable income.  In some cases, the HCE has the option of opening a SEP plan and deferring money to the SEP account.
  • Annuity contracts often allow investors to contribute unlimited amounts.  These contributions are after tax and form the basis in the annuity contract.  All the accumulated growth and earnings in the contract grow tax deferred.  Caution should be taken to avoid buying an annuity that has high internal fees and pays high commissions to the salesperson.  Always inquire as to the commissions to be paid, total expenses of the plan, and withdrawal options and penalties. 

Plan administrators should carefully consider the plan design to determine if changes could be made to manage this process more effectively.  HCE should seek guidance from qualified advisors to examine the various options available to assist them in making the critical long-term decisions regarding their retirement planning. 

by: Anthony McCallister, AIF®, J.D.

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To discuss this article further or to learn more about CapSouth Wealth Management, visit our website at www.capsouthwm.com or call 800.929.1001 to schedule an appointment to speak with an advisor.

Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice.

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