Inflation has cooled significantly over the past year, but many retired workers are still struggling with post-pandemic price increases. The following statistics are from the 2024 Retirement Confidence Survey conducted by the Employee Benefit Research Institute and Greenwald Research.

• Less than three-quarters of retirees believe they have saved enough money to live comfortably until retirement.
• More than two-thirds of retirees fear they will have to make significant spending cuts to keep up with inflation.

Many retired workers have turned their attention to Social Security’s 2025 cost of living adjustment (COLA), hoping the additional income will provide some measure of financial relief. But the Senior Citizens League recently cut its COLA forecast to 2.5%, the smallest benefit increase for retirees in four years.

Unfortunately, there is more bad news. While the Social Security Administration won’t finalize the 2025 COLA until later this week – the announcement will be made on October 10 – the official figure will likely underestimate inflation, causing benefits to lose purchasing power.

Here are the important details.

Image source: Getty Images.

The problem is how Social Security’s cost of living adjustments (COLAs) are calculated

Social Security’s annual cost of living adjustments (COLAs) are designed to protect the purchasing power of benefits by ensuring that payments increase at the same pace as inflation. For this purpose, inflation is measured using a subset of the consumer price index known as the Consumer Price Index for Urban Wage Earners and Office Workers (CPI-W).

The calculation itself is simple: the average CPI-W value for the third quarter of the current year (July to September) is divided by the average CPI-W value for the third quarter of the previous year. The percentage increase becomes a COLA next year. For example, the average CPI-W score increased 3.2% in the third quarter of 2023, giving Social Security benefits a 3.2% COLA in 2024.

The problem with this approach is that the CPI-W measures inflation based on the spending habits of younger working-age adults. But these people tend to spend their Social Security money differently than retirees. From the perspective of retirees, for example, the CPI-W underestimates the importance of housing and medical care and overestimates the importance of child care, education and transportation.

“The CPI-W actually excludes the spending patterns of retirees and disabled adults age 62 and older,” said Mary Johnson, an independent Social Security policy analyst who previously worked with the Senior Citizens League. That’s problematic because prices tend to rise faster in the spending categories that are more relevant to retired workers, meaning that, in their view, the CPI-W tends to underestimate inflation.

Social Security benefits are (arguably) on track to lose purchasing power in 2025

Experts have suggested replacing the CPI-W with the CPI-E, which measures inflation based on the spending habits of people age 62 and older. By comparison, the CPI-E places more emphasis on housing and medical care and less on child care, education, and transportation, theoretically making it a better indicator of inflation for Social Security recipients.

The CPI-E has historically risen faster than the CPI-W. According to the Congressional Research Service, between January 1985 and January 2024, the CPI-E increased 211% and the CPI-W increased 188%. That means Social Security benefits have lost significant purchasing power over the past few decades if the CPI-E is truly a better indicator of inflation for retirees. Unfortunately, this problem will repeat itself in 2024.

Housing costs (equivalent rent, utilities, furnishings, insurance) have risen faster than the overall CPI-W this year, while education and transportation costs have risen less quickly. This means that inflation in the spending categories that are more important to retirees is trending above average, while inflation in less important spending categories is trending below average.

The result of this combination is that CPI-E inflation has risen faster than CPI-W inflation year to date, as shown in the chart below.

Data source: Bureau of Labor Statistics.

As shown above, CPI-E inflation exceeded CPI-W inflation by three-tenths of a percentage point in the first eight months of 2024. That means Social Security’s 2025 COLA is (arguably) on track to underestimate inflation by three-tenths of a percentage point, causing benefits to lose purchasing power next year.

However, the gap between CPI-E inflation and CPI-W inflation widened to half a percentage point in August. If this trend continues in the coming months, Social Security’s 2025 COLA could underestimate inflation even more, in which case it would result in an even greater loss of benefit purchasing power next year.

Given this bad news, retired workers should continue to budget prudently. Additionally, readers looking for additional sources of income should consider certificates of deposit (CDs) or high-yield savings accounts. Interest rates are falling, but are still elevated compared to the 20-year average.