Social Security: Cost-of-Living Adjustments (COLAs) and the System’s Projected Financial Shortfall

Social Security: Cost-of-Living Adjustments (COLAs) and the System’s Projected Financial Shortfall

May 17, 2022
Social Security: Cost-of-Living Adjustments (COLAs) and the
System’s Projected Financial Shortfall
Recent news articles have suggested that the historically
were not indexed, and ad hoc legislation was required to
large 5.9% cost-of-living adjustment (COLA) payable in
create new brackets. So long as wage and price growth
January 2022 will have a negative impact on the projected
remained relatively stable, this approach kept initial
financial shortfall of the Social Security programs. If
benefits aligned with wage growth (to maintain replacement
inflation persists, another large COLA may be payable in
rates) and current benefits (benefits already in payment)
January 2023. This In Focus provides a brief description of
aligned with price growth (to maintain purchasing power).
the Social Security program, its projected financial
Inflationary conditions in the 1970s led to higher-than-
shortfall, and an overview of the annual COLA. It then
expected benefits as price growth outpaced wage growth.
addresses how the COLA is financed and how the COLA
affects the projected financial status of the Social Security
Through several amendments, Congress decoupled the
programs.
effect of wage and price growth. Under the current-law
benefit formula, a worker’s past earnings (up to age 60) and
Social Security Background and
the bend points in the formula used to progressively replace
Projected Financial Shortfall
earnings are indexed to the average wage index (AWI).
Social Security is a social insurance program that protects
Thus, initial benefits—which can be collected at the earliest
insured workers and their eligible family members against a
eligibility age (EEA) of 62—tend to increase with increases
loss of income due to the worker’s retirement, disability, or
in average wages. If benefits are claimed after the EEA, the
death. The program is comprised of Old-Age and Survivors
initial benefit is also indexed to prices as measured by the
Insurance (OASI) and Disability Insurance (DI) and is
Consumer Price Index for Urban Wage Earners and Clerical
referred to on a combined basis as OASDI. In 2022, about
Workers (CPI-W). Specifically, the initial monthly benefit
178 million workers will be employed in Social Security–
is adjusted based on the Social Security COLA for the
covered employment, and the program is expected to pay
period from benefit eligibility to benefit receipt. In addition,
benefits to more than 65 million beneficiaries.
benefits already in payment are adjusted annually based on
the Social Security COLA. Thus, after the EEA, benefits
Social Security is primarily self-financed through dedicated
tend to increase with increases in average prices.
payroll taxes (90.1% of total income in 2021). The
remainder of the program’s income comes in the form of
The Social Security COLA is based on the increase (if any)
federal income taxes paid by about half of beneficiaries on
in the CPI-W over a specified measurement period—that is,
a portion of their benefits and interest earned by assets held
the increase in the CPI-W from the third quarter average for
in the trust funds. In 2021, 99.0% of total expenditures went
the base calendar year (typically the previous calendar year)
toward monthly benefit payments.
to the third-quarter average for the current calendar year.
The COLA becomes effective in December of the current
Social Security’s costs currently exceed income. Because of
year and is payable in January of the following year.
this annual deficit, assets held in the trust funds (excess
(Monthly benefits reflect the benefits due for the preceding
revenues from prior years) are used to augment program
month.) In some years, there may be a decrease in the CPI-
income. Annual deficits are projected to continue
W over the measurement period. Such was the case for
throughout the program’s 75-year projection period. As a
COLAs computed in 2009, 2010, and 2015 (for benefits
result, trust fund assets are projected to decline steadily
payable in 2010, 2011, and 2016, respectively). Social
from $2.9 trillion in 2021 to zero in 2034. Following the
Security benefits are protected from a decrease in average
depletion of trust fund assets, scheduled tax revenues are
prices (i.e., a COLA cannot be negative). In those years,
projected to be sufficient to pay 78% of scheduled benefits
benefit amounts remained unchanged.
initially, declining to 74% by 2095 (under the intermediate
assumptions in the 2021 Annual Report of the Social
A 5.9% COLA was payable in January 2022, as announced
Security Board of Trustees, the trustees’ best guess of
on October 13, 2021, by the Social Security Administration.
future experience).
For a retired worker receiving the average monthly benefit
of $1,565 in 2021, the COLA resulted in about a $91
Wage and Price Indexing in Social
increase in benefits, to $1,656. Thus, COLAs result in
Security Benefit Calculations
higher benefit amounts for beneficiaries and lead to higher
The original benefit formula used to calculate Social
program costs. The 2021 Annual Report, submitted to
Security benefits separated a worker’s average monthly
Congress on August 31, 2021, projected a COLA of 2.4%
wages—average of nominal earnings from all years of
for 2023 (under the intermediate assumptions). The
employment—into brackets and applied a replacement rate
President’s FY2023 budget, submitted to Congress on
to each bracket. The parameters used to calculate benefits
March 28, 2022, projects a COLA of 4.3% for 2023. From
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Social Security: Cost-of-Living Adjustments (COLAs) and the System’s Projected Financial Shortfall
1976, when the first COLA was payable, to 2022, COLAs
increase costs, or decrease trust fund reserves have negative
have averaged 3.7%.
effects on the program’s financial status.
How Is the COLA Financed?
The CBB and COLA can interact in three possible
The cost of COLAs (i.e., benefit increases) have
combinations, and each combination affects the program’s
traditionally been at least partially offset by increases in
financial status in a different manner. One scenario is a
payroll tax revenues. Payroll taxes are levied on covered
payable (positive) COLA and an increase in the CBB. (This
earnings up to a maximum amount each year, the
has happened in most years.) A payable COLA would lead
contribution and benefit base (CBB). The CBB is
to higher benefit payments (costs), while the increase in the
commonly referred to as the taxable maximum. The CBB is
CBB would lead to an increase in the total amount of
a cap on both contributions and benefits. As a contribution
earnings subject to the payroll tax. That is, there would be
base, it establishes the maximum amount of a worker’s
an immediate increase in revenues and costs. The degree to
earnings subject to the payroll tax. As a benefit base, it
which the increase in revenues would offset the increase in
establishes the maximum amount of earnings used to
costs would depend on the relative magnitude of each
calculate benefits. The CBB is indexed to the AWI. Thus,
increase, among other factors. A second scenario is a
the amount of economy-wide earnings subject to the Social
payable COLA while the CBB remains unchanged (due to a
Security payroll tax generally increases each year. In 2022,
decrease in the AWI or the CBB rounding rule). A payable
the CBB increased to $147,000 (from $142,800 in 2021).
COLA would lead to higher benefit payments (costs), while
The 2021 Annual Report projected a CBB of $156,000 for
an unchanged CBB would result in roughly the same
2023 (under the intermediate assumptions). The President’s
amount of earnings subject to the payroll tax. Under such a
FY2023 budget projects a CBB of $156,300 for 2023.
scenario, there would be an immediate increase in costs and
relatively no change in revenues. A third scenario is no
The formula for determining the CBB is set by law (42
COLA (i.e., flat or declining price index) while the CBB
U.S.C. §430[b]). For any year after 1994, the CBB is equal
remains unchanged. (The CBB cannot increase if there is no
to the base for the year 1994 ($60,600) multiplied by the
COLA.) In this instance, there would be no immediate
ratio of the AWI for two years before the year for which the
change in revenues or costs.
amount is being calculated to the AWI for the year 1992
(i.e., 1994 minus 2), with the result rounded to the nearest
These scenarios present the immediate and first-order
multiple of $300. If the result is less than the current base,
effects of COLAs on Social Security’s financial status.
then the base is not reduced. That is, if the AWI decreases,
However, the combinations of changes in CBB and COLAs
resulting in a drop in the CBB, the CBB from the prior year
can have varying long-term effects and second-order
is used. Also, due to the $300 rounding rule, it is possible
effects. For instance, in one year there may be a COLA but
for the CBB to remain unchanged in years of little wage
no increase in the CBB, so the increase in costs would not
growth. In 2009, the AWI decreased by -1.51%, and as a
be offset by any increase in revenues. However, in
result, the CBB from 2010 to 2011 did not change.
subsequent years, there may be relatively small COLAs and
relatively larger increases in the CBB. Perhaps, over a
Between 1972 and 1977, and since 1982, the adjustment to
multiyear period, the increases in benefit costs would be
the CBB has been effective only when a COLA is payable.
more than fully offset by revenue increases, leading to
If there is no COLA, the CBB remains unchanged
improvements in Social Security’s financial status. That is,
regardless of wage growth. For example, no COLA was
any one year’s COLA or CBB imbalance may not have
payable in 2016. As a result, although the AWI increased in
long-term, lasting effects on the system’s finances.
2014 (the AWI from two years prior used to calculate the
2016 CBB), the CBB was unchanged from 2015 to 2016.
COLAs and CBB changes can have secondary effects as
well. Increases in the CBB are generally associated with
Congressional reports accompanying the Social Security
higher average benefits due to growth in the AWI.
Amendments of 1972 explicitly indicated that automatic
Conversely, if the AWI were to decrease, the CBB would
increases in the CBB were intended to provide financing for
remain unchanged, and average benefits would be lower
increases in benefits resulting from automatic COLAs and
than if wage growth were to increase or remain level. In this
from increases in the CBB itself. However, the degree to
instance, the CBB would remain unchanged. Moreover, any
which the increased benefits would be offset in any given
of these combinations may induce behavior changes, such
year is unclear. In general, it is thought that higher-COLA
as changes in claiming ages, which could also affect Social
years will be balanced by subsequent lower-COLA years.
Security’s financial status.
How Might COLAs Impact Social
CRS Report 94-803, Social Security: Cost-of-Living
Security’s Financial Status?
Adjustments, and CRS In Focus IF10522, Social Security’s
The financial health of Social Security is determined by the
Funding Shortfall, provide more detailed discussions on
combination of inflows (i.e., tax revenues and earned
COLAs and the projected financial shortfall, respectively.
interest) and outflows (i.e., benefit payments and program
administration). Simply speaking, it is the interactions
Barry F. Huston, Analyst in Social Policy
among revenues, costs, and the asset reserves held in the
Paul S. Davies, Specialist in Income Security
trust funds. Changes that increase revenues, decrease costs,
or increase trust fund reserves have positive effects on the
IF12109
program’s financial status. Changes that decrease revenues,
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Social Security: Cost-of-Living Adjustments (COLAs) and the System’s Projected Financial Shortfall

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https://crsreports.congress.gov | IF12109 · VERSION 1 · NEW