A closer look at figuring COLA

After President Barack Obama released his fiscal 2014 After President Barack Obama released his fiscal 2014 budget, a number of you wrote, asking, "What will this mean to me?" (April 26, 2013) Photo Credit: Getty Images

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There's nothing like proposed changes to Social Security to get readers of this column going. After President Barack Obama released his fiscal 2014 budget, a number of you wrote, asking, "What will this mean to me?"

Well, let's start with a quick refresher on the current system. To qualify for Social Security retirement benefits, you need to have worked and paid payroll taxes for at least 10 years. You can check your online benefits statement at socialsecurity.gov /mystatement to determine where you currently stand.

Full retirement age varies from 65 to 67 depending on the year of your birth. The general rule is that if you can afford to do so and are in good health, it pays to wait to retire until your full retirement age (FRA) before you claim benefits (and it's even better if you can delay until age 70 because your benefit increases). While you can choose to tap into the system as early as age 62, your benefit will be permanently lower -- for some as much as 25 percent less, which also could affect a non-working spouse, who also will claim based on your work history. Unfortunately, many Americans can't afford to delay -- they need the income as soon as possible.

There is one more part of the equation. The government adjusts the amount of your retirement benefit annually to account for rising prices. In 2013, the cost-of-living adjustment, or "COLA," was an increase of 1.7 percent.

But let's hit the pause button here. Social Security is not going broke any time soon. Yes, there are fewer workers paying into the system today than in the past, and indeed, more and more baby boomers retire every day. The Social Security 2012 trustee report projected that in 20 years (after 2033), payroll tax income would pay only about three-quarters of scheduled benefits through 2086.

But the trustees' report also offered a different way to think about Social Security -- as a share of gross domestic product, or the economy as a whole. Social Security costs equaled 4.2 percent of GDP in 2007, and the trustees project that these costs will increase gradually to 6.4 percent of GDP in 2035 before declining and remaining at about 6.1 percent of GDP from 2055 through 2086.

Many argue that 6 to 6.5 percent of GDP is a small price to pay to fund a program that provides about 37 percent of all income for Americans 65 and older, and a whopping 85 percent for those in the bottom 20 percent of incomes. That's why legislators and pundits have been floating so many ideas for enhancing the current system, which include increasing full retirement age, raising the Social Security wage base from the current level of $113,700 of earned income, increasing the Social Security payroll tax for high earners, means-testing Social Security benefits for retirees who have incomes above a certain threshold and/or changing the cost-of-living adjustment.

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The president's budget focuses on that last option by tinkering with the COLA calculation as a means to slow down the cost of the Social Security over the next decade.

The proposal would replace the current measure of inflation (a consumer price index for wage earners, or CPI-W) with one called "chained CPI," which the government has only been calculating since 2002. Advocates claim that chained CPI is a more accurate measure because it takes into account the fact that consumers respond to the rise in the price of one good by shifting to cheaper alternatives.

Chained CPI has shown an average rate of inflation that's 0.3 percent lower than the government's current measure, according to the AARP Public Policy Institute. The Obama administration says that this change in calculation would shave $110 billion from the budget over 10 years.

However, what would be the net effect of this change on retirees? According to the Center for Economic and Policy Research, the switch to chained CPI could reduce benefits for the average worker who retires at age 65 by about $650 per year by age 75, and by over $1,100 per year by age 85.

So, while some combination of these proposed changes could be made to bolster Social Security over the long term, many of them will shrink the already meager benefits of most retirees. Like it or not, this appears to be the new reality of retirement.

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We should all pay attention and plan accordingly.

Jill Schlesinger is editor-at-large for CBSMoneyWatch.com. She welcomes emailed comments and questions.

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