Should the Recent COLA Affect Your Financial Strategy?
With inflation running at multidecade highs, 2022 has been a difficult year for global stock and bond markets. Amid this backdrop, a silver lining is that Social Security beneficiaries are set to receive an 8.7% cost of living adjustment (COLA) in 2023.
This figure, which is the largest COLA in more than 40 years, presents questions about how the Social Security Administration calculates the COLA, how this adjustment affects your benefits and how inflation, and the resulting COLA, affects your claiming strategy. It’s crucial to evaluate how your claiming strategy fits into your financial goals and your big picture.
How the Social Security COLA Is Calculated
The COLA is based on the consumer price index (CPI) or, more specifically, on an index called the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). To arrive at the COLA, the Social Security Administration determines the difference between average prices of the CPI-W in the third quarter of the current year to those from the third quarter of the previous year. The change is then applied to benefits for the upcoming year. If the difference in the average CPI-W from one year to the next is 0% or negative, a 0% COLA is applied. The last time we had 0% COLA was in 2016.
How the COLA Affects Your Social Security Benefits<
For those already receiving Social Security benefits, the COLA is simply added to your current benefits and payable starting in January. For example, for a beneficiary receiving $2,500 per month in 2022, their benefit starting in 2023 will be $2,717.50 ($2,500 x 1.087).
For those beneficiaries age 62 or older who haven’t yet filed for Social Security, it’s important to note they also receive the COLA. However, the calculation is a bit more roundabout, which leads to a couple more acronyms (bear with me!). The COLA is applied to the primary insurance amount (PIA), which is the amount that you would receive at your full retirement age (FRA). Your Social Security benefit estimates at different claiming ages (more to follow on this important aspect) are then based on your new, COLA-adjusted PIA.
Further, Social Security PIA is computed based on your highest 35 years of earnings. Although the formula is somewhat complex, it’s important to understand that those earnings are also indexed for inflation. As such, for future Social Security beneficiaries who have not yet turned 62, past earnings are adjusted to reflect changes in average national wages and standards of living over time.
How the Social Security COLA Should Affect Your Claiming Strategy
The COLA should have little to no influence on your claiming strategy. After paying into the program for many years through payroll taxes, it may be natural to want to claim your benefits early to ensure you receive this bump — but you’re already receiving it! As previously described, you’ll automatically receive the COLA if you’re currently a Social Security beneficiary or if you’re age 62 or older and have yet to file for benefits. If you’re a future beneficiary and younger than age 62, you won’t receive the COLA directly, but you can reasonably expect your benefits to keep up with inflation through the program’s wage indexing methodology.
How Your Social Security Claiming Strategy Fits into Your Financial Goals
Social Security benefits grow 8% annually when delayed past your FRA until the maximum benefit is reached at age 70. Conversely, benefits are reduced when filing before your FRA. This reduction can be up to 30% when filing for benefits at age 62. The increase from delayed credits, or the decrease from filing early, is after the COLA, which, as previously noted, is first applied to your PIA.
Your Social Security claiming decision can have a permanent effect on you and your family, and, again, COLA bumps should have practically no sway on your decision to file. Your strategy should be based on your personal goals, expected longevity, assets and other sources of retirement income. Other factors, such as taxes, can also play a role.
For a specific example, if you’re implementing a series of Roth conversions in the “Roth conversion sweet spot” (the period from retirement until required minimum distributions commence at age 72), Social Security timing can have an impact. Up to 85% of Social Security benefits are taxable federally and may also be taxable at the state level, depending on where you live. That said, claiming too early can increase your adjusted gross income and make Roth conversions less attractive.
Everyone’s situation is different, and developing an effective Social Security strategy can be multifaceted and complex. Don’t let COLA announcements dictate your decision. Rather, work with your wealth manager and financial planner to determine the optimal strategy in the context of your financial plan.
As a final, related sidenote on more positive news of interest to many Social Security beneficiaries, Medicare part B premiums are set to fall an average of 3.1% in 2023.1 This comes as spending on new drugs and other care came in lower than expected in 2022. Along with the 2023 Social Security COLA, this decrease in healthcare costs should provide additional purchasing power relief for seniors.
Do you have questions about when to begin taking Social Security? Don’t worry, Creative Planning is here for you. We work with clients to plan for a wide range of retirement scenarios, with Social Security benefits playing an important role in the decision-making process. If you’d like help evaluating your retirement options, or to discuss any other financial matter, please schedule a call.
For more information about Social Security, contact the Social Security Administration office, or visit www.ssa.gov.