The Social Security Cost of Living Adjustment (COLA) forecast for 2025 has just been updated. There’s bad news in store for retirees.

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

• Fewer than three-quarters of retired workers believe they have enough money saved to live comfortably through retirement.
• More than two-thirds of retired workers are concerned that they will have to make substantial spending cuts to keep up with inflation.

Many retired workers have turned their attention to the 2025 cost of living adjustment (COLA), hoping that the additional income will provide some measure of financial relief. But the Senior Citizens League recently revised its COLA forecast to 2.5 percent, the smallest increase in benefits for retired workers in four years.

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

Here are the important details.

Image source: Getty Images.

The problem with 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 rate as inflation. To do this, inflation is measured by a subset of the consumer price index known as the Consumer Price Index for Urban Wage and Service Workers (CPI-W).

The calculation itself is simple: the average CPI-W from the third quarter of the current year (July to September) is divided by the average CPI-W from the third quarter of the previous year. The percentage increase becomes COLA the following year. For example, the average CPI-W increased 3.2% in the third quarter of 2023, so Social Security benefits received a COLA of 3.2% 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 money differently than retired workers on Social Security. For example, from the perspective of retired workers, the CPI-W underestimates the importance of housing and health care and overestimates the importance of childcare, education, and transportation.

“The CPI-W actually excludes the spending patterns of retired and disabled adults age 62 and older,” according to Mary Johnson, an independent Social Security policy analyst formerly associated with The Citizens League. This is problematic because prices tend to rise faster in spending categories that are more relevant to retired workers, meaning that the CPI-W tends to underestimate inflation from their perspective.

Social Security benefits are (probably) about to lose purchasing power in 2025

Experts have suggested replacing the CPI-W with the CPI-E, which measures inflation based on the spending patterns of people age 62 and older. Comparatively, the CPI-E puts more emphasis on housing and health care and less on childcare, education, and transportation, theoretically making it a superior indicator of inflation for Social Security recipients.

The CPI-E has historically risen faster than the CPI-W. Between January 1985 and January 2024, the CPI-E rose 211% and the CPI-W rose 188%, according to the Congressional Research Service. This means that Social Security benefits have lost significant purchasing power in recent decades, if the CPI-E is truly a better indicator of inflation for retirees. Unfortunately, this problem repeats itself in 2024.

Housing costs (rent equivalency, utilities, furniture, insurance) grew faster than the overall CPI-W this year, while costs associated with education and transportation grew less quickly. This means that inflation in spending categories that are more important to retirees tends to be above average, while inflation in less important spending categories is 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 outpaced CPI-W inflation by three-tenths of a percentage point in the first eight months of 2024. This means that Social Security’s 2025 COLA is (probably) on track to understate inflation by three tenths of a percentage point. percentage point, causing benefits to lose purchasing power next year.

That said, 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 understate inflation by an even greater degree, in which case benefits would lose even more purchasing power next year.

In light of 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 still high compared to the 20-year average.