After two years of 0% COLAs, inflation adjustments will resume in 2012, with a robust 3.6% benefit increase. Naturally, those who are already receiving Social Security benefits are celebrating the news (until they find out next week how much their Medicare premiums will rise).
COLAs also apply to unclaimed benefits
First, it's important to know that the primary insurance amount (PIA) will be increased by the COLA, whether or not you have started receiving benefits. You do not need to be receiving benefits to take advantage of the COLA increase.
Here's how it works. Prior to age 60, a person's future benefit is affected by increases in the national average wage index. The average wage index determines the indexing factors that will be used to adjust each year's earnings for their average indexed monthly earnings (AIME), and it determines the bend points used to calculate the PIA. Historically, the growth in the average wage index has exceeded the growth in the consumer price index. So younger people's benefits are actually increasing faster than older people's benefits (this is one of the areas being considered for Social Security reform).
Once a person's PIA is officially calculated at age 62, it becomes subject to cost-of-living increases as determined by the CPI-W. To see how this works, let's take a look at our example for Boomer Bob, who we'll say was born in June of 1949 and therefore turned 62 in June of 2011. As a maximum earner from 1971 through 2010, his PIA was calculated in 2011 as follows:
AIME = $7,928
PIA =
0.90 x $749 +
0.32 x $3,768 +
0.15 x $3,411 = $2,391
(Source: SSA Downloadable Detailed Calculator)
Benefit will be based on COLA-adjusted PIA
As you already know, Boomer Bob's actual benefit will depend on when he applies. If he had applied as soon as he turned 62, in June of 2011, his benefit would be 75% of his 2011 PIA, or $1,793. Then in 2012, he would get a 3.6% raise to bring his benefit up to $1,858. This is a $65 increase.
But what if, Boomer Bob decides to wait until he is 70 to claim his benefit? Then his benefit will increase by two measures: 1) the gradually decreasing actuarial reduction before full retirement age and the 8% annual delayed credits after full retirement age, and 2) annual COLAs between now and age 70. We know that his PIA will go up by 3.6% next year. Beyond that, we can't know what future COLAs will be, but let's say they're 2.8%. Here will be the effect upon Boomer Bob's benefit:
| Starting Benefit Including COLAs and Actuarial Reduction or Delayed Credits | ||||
| Year | Age | COLA-adjusted PIA | Benefit as % of PIA if he applies this year | Starting benefit |
| 2011 | 62 | $2,391 | 75.0 | $1,793 |
| 2012 | 63 | $2,477 | 80.0 | $1,981 |
| 2013 | 64 | $2,546 | 86.7 | $2,207 |
| 2014 | 65 | $2,618 | 93.3 | $2,442 |
| 2015 | 66 | $2,691 | 100 | $2,691 |
| 2016 | 67 | $2,766 | 108 | $2,987 |
| 2017 | 68 | $2,844 | 116 | $3,299 |
| 2018 | 69 | $2,923 | 124 | $3,625 |
| 2019 | 70 | $3,005 | 132 | $3,966 |
As you can see, there's a huge disparity between the $1,793 he'll receive in 2011 if he starts at 62, and the $3,966 he'll receive in 2019 if he starts at 70. So let's even things out a bit by looking at what his benefit will be in 2019, when he is 70, depending on when he started benefits. Again, we are assuming a 3.6% COLA in 2012 and 2.8% COLAs thereafter.
| Benefit at Age 70 Based on Claiming Age | |||
| Year | Age | Age benefit started | COLA-adjusted benefit |
| 2019 | 70 | 62 | $2,254 |
| 2019 | 70 | 63 | $2,403 |
| 2019 | 70 | 64 | $2,605 |
| 2019 | 70 | 65 | $2,804 |
| 2019 | 70 | 66 | $3,005 |
| 2019 | 70 | 67 | $3,245 |
| 2019 | 70 | 68 | $3,486 |
| 2019 | 70 | 69 | $3,727 |
| 2019 | 70 | 70 | $3,966 |
So his income at age 70 will be substantially lower if he applies at 62 than if he applies at 70.
One of the points we like to make when encouraging clients to delay benefits is that COLAs magnify the disparity between early and late claiming. So let's see what Boomer Bob's COLA raise would be when he turns 71 depending on when he started benefits. Again, we'll assume 2.8% | Benefit Raise at Age 71 if COLA is 2.8% | |||
| Age benefit started | COLA-adjusted benefit at age 70 | Monthly raise at age 71 if COLA is 2.8% | Annual raise at age 71 if COLA is 2.8% |
| 62 | $2,254 | $63 | $756 |
| 63 | $2,403 | $67 | $804 |
| 64 | $2,605 | $73 | $876 |
| 65 | $2,804 | $78 | $936 |
| 66 | $3,005 | $84 | $1,008 |
| 67 | $3,245 | $91 | $1,092 |
| 68 | $3,486 | $98 | $1,176 |
| 69 | $3,727 | $104 | $1,248 |
| 70 | $3,966 | $111 | $1,332 |
Note how much bigger the raises are on the higher benefit amounts. We can assume that all Social Security recipients are celebrating the 3.6% COLA increase announced yesterday. But some recipients are probably celebrating more than others. These would be the ones who received higher raises because the 3.6% increase was applied to a higher benefit amount.
In today's low interest rate, low return environment, the fixed Social Security formula that escalates the starting benefit for delayed claiming is looking like a better deal all the time. And when COLAs are applied to the higher amounts, annual raises become significant as well.
After two years of 0% COLAs, many people have forgotten how valuable these inflation adjustments can be. This is where our Social Security calculators come into play. We can show clients and prospective clients how much more they stand to receive over their lifetime if they delay the start of their Social Security benefits, thanks to both delayed credits and COLAs.
By the way, automatic COLAs started in 1975 and have averaged 4.2%. Removing the double-digit COLAs of 1980 and 1981, the COLA has still averaged 3.7%. In light of this, I think our 2.8% COLA projections are reasonable.
Other COLA-related changes
In today's low interest rate, low return environment, the fixed Social Security formula that escalates the starting benefit for delayed claiming is looking like a better deal all the time. And when COLAs are applied to the higher amounts, annual raises become significant as well.
After two years of 0% COLAs, many people have forgotten how valuable these inflation adjustments can be. This is where our Social Security calculators come into play. We can show clients and prospective clients how much more they stand to receive over their lifetime if they delay the start of their Social Security benefits, thanks to both delayed credits and COLAs.
By the way, automatic COLAs started in 1975 and have averaged 4.2%. Removing the double-digit COLAs of 1980 and 1981, the COLA has still averaged 3.7%. In light of this, I think our 2.8% COLA projections are reasonable.
Other COLA-related changes
- The maximum taxable wage base rises to $110,100 in 2012, up from 106,800 in 2011.
- The earnings test before full retirement age rises to $14,640 in 2012, up from $14,160 in 2011.
- The earnings test in the year a person reaches full retirement age rises to $38,880, up from $37,680.
- The maximum Social Security benefit for a maximum earner retiring in 2012 will be $2,513, up from
$2,366 in 2011.
