With inflation running at multi-decade highs, 2022 has been a difficult year for global stock and bond markets. Amidst 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 affects your benefits, and how inflation, and the resulting COLA, affects your claiming strategy. It’s then 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 a subset of the CPI known as 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 average prices in 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, then a 0% COLA is applied. The last time we had 0% COLA was back in 2016.
How the COLA Affects Your Social Security Benefits
For those already receiving Social Security, the COLA is simply added to your current year 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 who are age 62 or older and haven’t yet filed for Social Security, it’s important to note that 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, or 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.
Important Information for Aramcons on the Windfall Elimination Provision
If you qualify for Social Security retirement benefits and a retirement pension from a job in which you did not pay into Social Security, you may be affected by WEP. This pension would be considered “non-covered,” and the Aramco Retirement Income Plan, or RIP, falls into this category. Generally, WEP reduces your PIA based on your years of substantial Social Security earnings. Furthermore, if your spouse is claiming a spousal Social Security benefit (up to 50% of the primary worker’s benefit), their spousal benefit would be based off your benefit after WEP has been factored in.
The good news is that even if you’re subject to WEP, you still receive Social Security COLAs. Additionally, survivor benefits are not affected by WEP, which would be removed for your spouse, or any other family members, if you were to pass away. Finally, if you have 30 or more years of substantial Social Security earnings, you are not subject to WEP and would receive your full benefit.
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 FICA taxes, it may be natural to want to claim your benefits early to ensure you receive this bump, but you already are! 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 full retirement age, or 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% if filing for benefits at age 62. The increase from delayed credits, or the decrease from early filing, is after the COLA, which as we previously noted is first applied to your primary insurance amount, or 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, your assets, and your other sources of retirement income. Other factors such as taxes can play a role. For a more 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 multi-faceted and complex. Don’t let COLA announcements dictate your decision. Rather, work with your Wealth Manager and your Financial Planner to determine the optimal strategy in the context of your financial plan.
As a final, related side note on more positive news of interest to many Social Security beneficiaries, Medicare part B premiums are set to fall an average 3.1% in 2023. 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 some additional purchasing power relief for Seniors!
To learn more about how your Social Security benefits fit into your retirement picture, or discuss claiming strategies, please email gabrielle.reilly@creativeplanning.com so we can help you make the most of your benefits, given your unique retirement goals.
References:
https://www.thinkadvisor.com/2022/09/27/medicare-part-b-premium-to-fall-3-1-in-2023/
SSA.gov:
https://www.ssa.gov/oact/cola/colaapplic.html
https://www.ssa.gov/oact/cola/awifactors.html
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