YOU DECIDE: What’s the best “COLA”?

Date posted: February 1, 2013

Dr. Michael Walden is William Neal Reynolds professor of agricultural and resource economics at N.C. State University.Dr. Michael Walden is William Neal Reynolds professor of agricultural and resource economics at N.C. State University.

Media Contact: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

By Dr. Mike Walden
North Carolina Cooperative Extension

A COLA war is going on. It hit the headlines a couple of months ago, has now subsided but is threatening to come back. It’s a war that not only can affect those who enjoy liquid refreshments but potentially everyone!

So is this a war between the big-name soda manufacturers? Actually, it’s not. I’m not talking about the best-tasting or most thirst-quenching carbonated beverage. Instead, I’m referring to the best “cost-of-living adjuster”!

Now, before you tune out, let me remind you, this version of the COLA war has the potential to affect everyone. This is because the front where the war will be waged is Social Security, and 90 percent of us are in the Social Security system. So using a popular current phrase, virtually all of us have some skin in this fight.

But just what is this COLA war? It’s a discussion (war is really too harsh a term) about the best index to use to adjust future Social Security payments received by retirees.

When Social Security was introduced in the 1930s, payments to retirees were not periodically changed to keep up with the cost of living. This didn’t begin until the 1970s, when price inflation started to be a big problem. Now, each year retirees receiving Social Security receive an increase in the amount they receive based on how some broad increase in average prices has changed.

This annual adjustment in Social Security payments is a big help to retirees. Even though the annual change can be small, over time it can accumulate to an impressive gain. For example, if a 3 percent increase is received each year for 10 years, then after a decade, the Social Security recipient’s checks will be more than one-third (with compounding) higher.

However, the big question is, What method should be used to make the annual adjustments to Social Security payments? Currently, the government uses its main inflation gauge — the Consumer Price Index, or CPI — to make these adjustments.

The CPI tracks prices in a “market basket” of products and services typically bought by households. The prices are weighted by their relative importance to households’ overall spending — meaning, for example, gasoline gets a larger weight than a can of peas — and then the weighted prices are averaged and converted to an index for ease of comparison. So, for example, a CPI of 200 compared to a CPI of 100 indicates weighted average prices have doubled. CPI values can be found at www.bls.gov.

So the CPI sounds reasonable, right? Not everyone agrees. One criticism has been that changes in the CPI won’t reflect how prices change for every household, because people differ in what they buy in their market basket.

Of course, this is correct, but we shouldn’t expect the government to have a customized CPI for every household. However, while conceding this point, retired households have long complained that their spending patterns do markedly differ due to the larger proportion spent on medical care. This has led to calls for a special “senior citizen CPI” to adjust Social Security pensions.

But the new COLA conflict is over a different issue. It has to do with how frequently the market basket is updated. The current CPI assumes that what we buy changes infrequently, approximately every two years.

Of course, this is unrealistic. Therefore, a revised CPI — the “chained CPI” — has been developed. It is designed to reflect changes in household buying over time due to two factors: as new products are introduced or buying preferences change and as we shift out of products and services where prices have risen to products and services where prices have fallen or remained stable.

It’s the last factor that has created the controversy. Say the price of gasoline jumps. The traditional CPI would assume we would continue buying the same gallons of gasoline, so the full impact of the gas price increase would be reflected in the CPI.

Yet under the new chained CPI, there would be an assumption we would purchase slightly fewer gallons, so the “weight” in the gasoline component of the CPI wouldn’t be as large as with the traditional method.

This means inflation with the chained CPI will be more modest, and programs like Social Security will save money because pensions to retirees will rise at a slower pace. Indeed, calculations suggest Social Security could save more than $100 billion over the next decade if the chained CPI is used to adjust future payments.

This has led some to claim that using the chained CPI for the Social Security COLA would mean a cut in payments for retirees. Other say, no, it’s merely a more realistic COLA that will extend the life of Social Security.

Since I’m now eligible to receive Social Security, I’ll be watching this COLA war if it is renewed. So, what’s the right COLA for you? You decide!

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Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University’s College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The College of Agriculture and Life Sciences communications unit provides his You Decide column every two weeks. Previous columns are available at http://www.cals.ncsu.edu/agcomm/news-center/tag/you-decide

Related audio files are at http://www.cals.ncsu.edu/agcomm/news-center/category/economic-perspective/

 

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