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What Does the "Chained CPI" Social Security Adjustment Really Mean to Seniors

Recently, President Obama submitted a budget to Congress that would have clear and relatively quick impacts on the finances of retirees. It included proposals that would affect Social Security benefits. If you are retired or close to retirement, what does this mean for you?

In the budget proposal, annual inflation adjustments to Social Security benefits would be reduced. The mechanism is a move to the so-called “chained CPI” method for calculating inflation. The logic is that the standard method of calculating inflation – the Consumer Price Index or CPI – overestimates inflation. The reason is that people adjust their purchases to compensate for the higher prices. To give you an example, if the price of beef goes up, people will turn to cheaper alternatives (eg chicken). Therefore, the actual inflation rate is actually lower than the CPI estimates and the Social Security adjustment should be less to reflect this.

Sounds reasonable, right? However, what are the implications? Current estimates indicate that switching to a chained CPI inflation adjustment for Social Security would reduce the annual adjustment by about 0.25%. If, for example, the CPI estimates inflation at 3%, the chain-linked CPI would bring it down to 2.75%. Social Security checks would be adjusted upward by 2.75%, not 3%.

That doesn’t sound like much. But let’s do the math. At the end of a 30-year retirement, assuming an annual inflation rate of 3%, you will receive 6.8% less with the chained CPI. This assumes you started with the average 2012 Social Security benefit of $1,250/month. Over 30 years, this would represent a cumulative loss of over $28,000 in benefits using the chained CPI adjustment. Some estimates place this difference as much as 9.4% less or more than $38,000 in lost accrued benefits for the average retiree. This number could be more or less depending on your starting benefit. So what seems like a minor change can have big ramifications when you look at the long term.

From the government’s point of view, it is a way of reducing the deficit. They estimate that over 10 years the savings would be approximately $341 billion. Of this amount, $127 billion would come from cuts to Social Security benefits, about $89 billion from other programs (the social safety net) and $124 billion from bracket indexation.

Wow, wait a minute. I understand the reductions in social security benefits, but what is this indexing of tax brackets? Well, the CPI is also used to adjust federal income tax brackets each year for inflation. This protects taxpayers from being pushed into higher tax brackets due to inflation. If the chained CPI adjustment is applied, you have less protection. So, as a senior, you could potentially be dealt a double whammy. First, you receive less social security benefits. Second, depending on your income, you could be pushed into a higher tax bracket.

Now I understand that the country is in a time of need. However, before you start getting too patriotic, let’s do a reality check: Are the assumptions behind the chained CPI correct?

• First, as prices rise, people shift their purchases to cheaper alternatives. Nothing wrong with that assumption. That’s exactly how people react. So here I am in 2013 and I stop buying expensive beef and switch to cheaper chicken. However, fast forward to 2014 and inflation is on the rise. I have already opted for the cheapest options, but my social security check does not sufficiently compensate for inflation. Where am I going now? You see, the chained CPI logic is very time-limited and unless you have the ability to switch to cheaper alternatives every year, it’s flawed logic. As a Social Security recipient, you could find yourself in a deeper financial hole each year.

• Second, some economists argue that the currently used CPI adjustment, based on costs for urban workers, underestimates rising costs for the elderly. Indeed, the elderly disproportionately purchase goods and services whose inflation rates are higher than the costs estimated by the CPI. An example of this would be healthcare and healthcare related products. So, if the current CPI adjustment is currently undercompensating the elderly for inflation, a chained CPI adjustment would only make the situation worse.

Switching to a chained CPI may seem a bit technical and of lesser consequence until you start analyzing the numbers. Some predict a rather alarming poverty rate among baby boomers. These proposed changes to Social Security will only make the situation worse. This is something you need to think about!

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