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Social Security: The Conspiracy Theory 98% of Retirees Believe (But You Shouldn't)

Because the Social Security Administration calculates annual COLAs based on the CPI for Urban Wage Earners and Clerical Workers, also known as CPI-W, the small size of annual benefit increases reflects the slow pace of price increases that the general public has seen in recent years. If you believe the CPI-W reflects the actual price changes that Americans experience in their daily lives, then slower benefit growth during periods of lower inflation is appropriate to keep purchasing power constant.

Source: Author, based on SSA data. Note: Year indicates when the COLA is announced, with each adjustment taking effect at the beginning of the following year.

However, many retirees believe the CPI-W doesn't do a good job of measuring their expenses. The Senior Citizens League noted that one possible alternative would involve using an experimental measure known as the CPI-E, which focuses on the prices of goods and services that Americans age 62 and older need.

Interestingly, though, switching to a measure that's geared toward the elderly wouldn't necessarily make COLAs any larger. In 2013, researchers at the Congressional Budget Office looked at the effects of having hypothetically switched to CPI-E-based COLAs in 2001, and their analysis concluded that using the CPI-E to drive COLAs made only a minimal difference in the past and could actually lead to smaller adjustments in the future. The biggest reason is that health care costs have moderated dramatically in recent years, and because retirees tend to need more health care than the general population, changing health care prices has a greater impact on changes in the CPI-E. At the same time, though, the CBO researchers were skeptical that they could accurately measure health care costs, given how hard it is to determine how much individuals really pay for given medical services.

One basic problem with Social Security COLAs is that the rationale behind measuring inflation is difficult for many to understand. Even economists argue about whether the methodology behind various CPI measures is sound, which has led to debate over further adjustments that could further reduce inflation rates.

Image courtesy Congressional Budget Office.

Questioning the inflation methodology

Two of the most difficult concepts behind various types of COLAs involve what's known as the substitution effect and hedonic or quality-based adjustments. The substitution effect measures the tendency of shoppers to buy less of something when its price rises if there's a more reasonably priced substitute. The government will increase the weighting of the bargain-priced substitute to reflect the effect, which tends to smooth down the increased price.

Quality adjustments are more controversial because they often involve more subjective assessments of what makes a particular good more or less valuable. For instance, when a computer or electronic device is more powerful than its predecessor but costs the same, inflation figures will treat it as though the price fell, with the rationale being that the consumer got more bang for the buck in terms of higher quality. Similarly, if a product gets shoddier at the same price, inflation figures will treat it as though the price of the good actually went up.

Ben Bernanke. Source: Federal Reserve.

Yet most economists believe that regardless of the specific methodology you use, you're not likely to see dramatic differences among inflation figures. Former Federal Reserve chair Ben Bernanke noted in a 2012 press conference that "These various [inflation] measures, the CPI and others, the [Personal Consumption Expenditures Price Index] and others, move very closely together."

Moreover, the Bureau of Labor Statistics asserts that the impact of quality adjustments has actually raised inflation rates. Although it admits that substitution adjustments reduce measured CPI, the BLS doesn't appear to believe that the impact is dramatic enough to constitute an unfair bias.

The real policy shift retirees want

Nevertheless, most of the debate around COLAs centers on the fact that retirees simply don't want their benefits cut. The most recent push among some lawmakers has been to adopt what's known as the Chained CPI , an alternative measure that most believe would create smaller COLAs than the current method. In response, political pressure has emerged to expand Social Security; various proposals include changing the formula for calculating benefits to favor low- and middle-income retirees, boosting minimum benefit amounts to 125% of the poverty line, and adopting minimum COLA increases that would raise monthly payments even in years in which inflation was flat.

It's easy to understand why Social Security recipients are frustrated with the government, given the meager size of benefit increases in recent years. Yet rather than simply believing in a government conspiracy theory, the more productive way to make progress is to actively engage in the debate about whether explicitly raising Social Security benefits is the best way to ensure that retirees have the financial stability they need.

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The article Social Security: The Conspiracy Theory 98% of Retirees Believe (But You Shouldn't) originally appeared on Fool.com.

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