Social Security's 2025 cost-of-living adjustment (COLA) took effect in January. Benefits will increase 2.5% this year, the smallest pay bump for seniors since 2021. Indeed, more than half of retired workers surveyed by The Motley Fool in October said the COLA was insufficient.
However, the situation has worsened since then because inflation has reaccelerated since the COLA was calculated. Here's what that unpleasant surprise means for Social Security beneficiaries in 2025.
Image source: Getty Images.
Social Security's 2025 COLA likely underestimated inflation in 2024
Social Security's annual cost-of-living adjustments (COLAs) are designed to protect the purchasing power of benefit payments from inflation. In this case, inflation is measured with a subset of the Consumer Price Index known as the CPI-W, which stands for the Consumer Price Index for Urban Wage Earners and Clerical Workers.
The calculation is simple: The CPI-W from the third quarter of the current year (July through September) is compared to the same number from the prior year, and the percent increase becomes the COLA in the next year. For example, the CPI-W increased 2.5% in the third quarter of 2024, so Social Security benefits increased 2.5% in 2025.
Here's the unpleasant surprise: That number probably underestimates the true inflation rate in 2024, meaning benefits will have less spending power this year. That reason is that CPI-W inflation has reaccelerated since the third quarter ended. After bottoming at 2.2% in September, the CPI-W increased 2.4% in October and 2.6% in November. Additionally, a forecasting tool from the Federal Reserve Bank of Cleveland suggests that trend continued in December.
Social Security's 2024 COLA underestimated inflation in 2023
The Senior Citizens League, a nonprofit advocacy group, estimates the purchasing power of Social Security benefits declined 20% between 2010 and 2024 due to insufficient cost-of-living adjustments. One reason for the problem is that CPI-W measures inflations based on the spending habits of working-age adults, but they often spend money differently than retired workers.
Another reason for the problem is that COLAs are calculated by extrapolating third-quarter CPI-W data to the full year. For example, CPI-W inflation increased 3.2% in the third quarter of 2023, which led to a 3.2% COLA in 2024. But the full-year CPI-W rose 3.8% in 2023. That means the COLA underestimated inflation by sixth-tenths of a percentage point. So, benefits lost buying power.
That problem repeated itself in 2024. The average monthly CPI-W reading increased 2.9% through November, but that number may get larger after the December reading is published later this month. That means the 2.5% COLA in 2025 likely underestimated inflation in 2024 by at least four-tenths of a percentage point. So, benefits lost buying power again.
To be clear, we are not talking about huge sums of money. The average Social Security benefit for retirees is projected to increase by $49 per month after the 2.5% COLA in 2025. However, the average benefit would have increased by about $56 per month had the 2025 COLA been 2.9%. That puts the average shortfall for retirees at less than $100 for the full year.
Unfortunately, the problem compounds on itself over time. A retiree with average benefits in 2023 would get an extra $19 per month in 2025 had the last two COLAs been based on the full-year CPI-W rather than the third-quarter reading. For those beneficiaries, the shortfall will exceed $200 this year. That is a more substantial loss in purchasing power.
As a small consolation, retirees can take advantage of elevated interest rates to earn a little extra income in 2025, which may compensate for any shortfall in Social Security benefits. Several financial institutions offer attractive rates on certificates of deposit (CDs) and high-yield savings accounts.
