Social Security recipients receive an annual cost-of-living adjustment (COLA) to protect the purchasing power of benefits from inflation. Retirees always look forward to these increases, but anticipation for the 2025 COLA is unusually high due to the difficult economic climate.

While inflation has cooled significantly in recent months, rising prices have been a serious burden since the pandemic. In fact, the percentage of U.S. adults who view inflation as their most pressing financial problem is set to hit a record high in 2024, according to Gallup.

The Social Security Administration will announce the official COLA for 2025 on Oct. 10, but the Senior Citizens League estimates that benefits will increase by 2.5% next year. That would be the lowest COLA Social Security recipients have received since 2021. But there’s a more serious aspect to the situation.

Social Security’s 2025 COLA could underestimate real inflation, causing benefits to lose purchasing power. That would be especially unfortunate since the exact same thing happened in 2024, and Social Security’s purchasing power hasn’t declined for two years in a row since 2021. Read on to learn more.

The purchasing power of social benefits is declining

The average Social Security benefit for retirees was $1,176 per month in December 2010. By January 2024, that amount has risen to $1,860 per month. However, the Senior Citizens League (TSCL), a nonprofit organization that advocates for Social Security and Medicare, estimates that the average Social Security benefit for retirees would need to be 20% higher to fully account for inflation over that period.

To be more specific, the average retiree’s pension should have been $2,230 in January 2024. That means Social Security’s annual cost-of-living adjustments (COLAs) have lagged so far behind inflation that benefits have lost 20% of their purchasing power since 2010. TSCL reached that conclusion using a proprietary inflation index weighted to a subset of the Consumer Price Index, known as the CPI-E.

Importantly, COLAs are currently calculated using a different subset of the consumer price index, called the CPI-W. But the CPI-W measures inflation based on the spending habits of workers, a group that spends its money differently than retirees on Social Security benefits. For example, retirees often spend more on housing and health care and less on clothing, education and transportation.

The CPI-E is more appropriate for Social Security recipients because it measures inflation based on the spending habits of people age 62 and older. For this reason, several politicians have proposed legislation that would replace the CPI-W with the CPI-E in the COLA calculation. These include the Law on the Protection and Preservation of Social Security was recently reintroduced by Senator Mazie Hirono (D-HI) and Representative Jill Tokuda (D-HI). But any changes to the law are unlikely to happen for several years at the earliest.

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Social Security’s COLA could do something in 2025 that it hasn’t done since 2021

If the CPI-E is indeed a better indicator of inflation for welfare recipients, then benefits lose purchasing power in years when the CPI-E rises faster than the CPI-W. Which brings me to the bad news: The 2025 COLA is on track to underestimate CPI-E inflation for the second year in a row, which was last the case in 2020 and 2021.

In other words, 2025 will be the second year in a row that Social Security benefits have lost purchasing power. But this time, the problem is even more severe. In 2020 and 2021, the CPI-E exceeded the CPI-W by 0.1% and 0.3%, respectively. For comparison, in 2023, the CPI-E exceeded the CPI-W by 0.8%, and in August 2024, it was 0.5% ahead of the CPI-W.

This means that not only will Social Security benefits lose purchasing power next year, but the loss of purchasing power will likely be even more severe than in 2020 and 2021. The last time Social Security’s COLA underestimated CPI-E inflation by such a significant margin over a two-year period was in 2016 and 2017.

Unfortunately, welfare recipients have few options to defend themselves other than managing their finances carefully and earning additional income through part-time work. S&P500 is currently trading near its record high, so now is a good time to sell some shares. Retirees should also consider putting money away in certificates of deposit (CDs) or high-yield savings accounts. Both could provide additional cash flow next year.

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Trevor Jennewine does not own any stocks mentioned. The Motley Fool does not own any stocks mentioned. The Motley Fool has a disclosure policy.

Social Security’s 2025 COLA could do something it hasn’t done since 2021 — and that’s not good news. Originally published by The Motley Fool