New Here? Get the Free Newsletter

Oblivious Investor offers a free newsletter providing tips on low-maintenance investing, tax planning, and retirement planning. Join over 21,000 email subscribers:

Articles are published Monday and Friday. You can unsubscribe at any time.

How Do Social Security Inflation Adjustments Work?

A reader writes in, asking:

“I’d be interested in an article on the specifics of Social Security inflation adjustments. I have a vague awareness that my wages are indexed so that my wages from early years count for more than just the actual dollar amount earned. And I also know that the SSA publishes a COLA figure every year for people already receiving benefits. Are those the same thing? And does a person have to file for benefits in order to start getting the COLA?”

The indexing of prior-year earnings is completely separate from the annual cost-of-living adjustments. Let’s discuss how each works.

Wage/Earnings Indexing

Wage indexing occurs at one point in time: in the year you turn 62 — or the year in which you die or become disabled if such happens before you reach age 62.

All of your wages (and net earnings from self-employment) up to 2 years prior to the year in question are indexed based on the national average wage index (NAWI) — sometimes just referred to as the average wage index (AWI). This can be roughly thought of as adjusting your old earnings for “wage inflation” up to age 60.

Example: Bob (alive and not disabled) turns 62 in 2020. All of Bob’s historical earnings up to 2018 are indexed based on the ratio of NAWI in 2018 to NAWI in the year of the earnings in question. So for example if Bob’s earnings in a given earlier year were exactly twice the NAWI figure for that year, then his earnings for that year would essentially “count for” twice the 2018 NAWI.

In the year 2000, NAWI was $32,154.82. If Bob earned twice that amount (i.e., $64,309.64) in the year 2000, then his 2000 earnings would be adjusted to twice the 2018 NAWI when originally calculating his benefit. In 2018, NAWI was $52,145.80, so Bob’s year-2000 earnings would count for $104,292 in 2018 dollars.

Earnings after age 60 are not indexed. In most cases this means that earnings after age 60 actually count for more than they would if they were indexed — because if they were indexed, they’d have to be indexed downward to age-60 dollars, given that NAWI usually grows over time. (There are exceptions of course. NAWI shrank in 2009 with the recession, and it’s certainly going to be lower for 2020 than it was for 2019.)

Another relevant point here — one you may have seen discussed in the news lately — is that your Social Security benefit is ultimately rather dependent on the NAWI figure in the year you turn age 60. If NAWI is low in that year, all of your prior earnings will be multiplied by the low age-60 NAWI. While we won’t know 2020 NAWI until (roughly) September 2021, it’s clear that the figure will be unusually low, given the dramatic amount of earnings loss this year. This is not a good thing for people born in 1960. (And to the extent that it doesn’t recover by 2021, this is not a good thing for people born in 1961.)

Cost-of-Living Adjustments (COLA)

The second type of indexing is the annual cost-of-living adjustment based on actual price inflation. Beginning with the year you turn 62 (or, if earlier, the year you die or become disabled), each year, your primary insurance amount is indexed upward based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

Specifically, the COLA for a given year is based on the average of the CPI-W for the third quarter of the prior year, divided by the average of the CPI-W for the third quarter of the year before that. For example, the average CPI-W from July-Sept of 2019 was 1.6% higher than the average CPI-W from July-Sept of 2018, which is why we had a 1.6% COLA in 2020.

If the calculated figure is negative (i.e., CPI-W went down), then there is no COLA rather than there being a negative COLA. And in the following year, the denominator in the calculation will be the third quarter CPI-W from the last year for which there was an inflation adjustment. For example, in 2015, the third quarter average CPI-W was lower than in 2014. So there was no COLA for 2016. Then, in 2017, the COLA was calculated based on the ratio of average CPI-W from third quarter 2016 relative to third quarter 2014 (rather than being compared to 2015 as would typically be the case).

Finally, to answer the reader’s second question, a critical point about Social Security cost-of-living adjustments is that they do not depend on whether or not you have claimed your retirement benefit. That is, you will get the applicable COLAs beginning age 62 onward, regardless of the age at which you file for your retirement benefit.

Want to Learn More about Social Security? Pick Up a Copy of My Book:

Social Security cover Social Security Made Simple: Social Security Retirement Benefits and Related Planning Topics Explained in 100 Pages or Less
Topics Covered in the Book:
  • How retirement benefits, spousal benefits, and widow(er) benefits are calculated,
  • How to decide the best age to claim your benefit,
  • How Social Security benefits are taxed and how that affects tax planning,
  • Click here to see the full list.

A Testimonial from a Reader on Amazon:

"An excellent review of various facts and decision-making components associated with the Social Security benefits. The book provides a lot of very useful information within small space."
Disclaimer: By using this site, you explicitly agree to its Terms of Use and agree not to hold Simple Subjects, LLC or any of its members liable in any way for damages arising from decisions you make based on the information made available on this site. I am not a financial or investment advisor, and the information on this site is for informational and entertainment purposes only and does not constitute financial advice.

Copyright 2020 Simple Subjects, LLC - All rights reserved. To be clear: This means that, aside from small quotations, the material on this site may not be republished elsewhere without my express permission. Terms of Use and Privacy Policy

My new Social Security calculator (beta): Open Social Security