No, you didn’t miss the memo.  The government hasn’t announced any plans to cut Social Security.  At least not overtly.  They have, however (in my opinion), been covertly reducing the value of Social Security payments for years.  How?

In order to account for inflation, Social Security payments have a cost of living adjustment built in.  If inflation (as measured by the Consumer Price Index) is 3 percent, payments are increased by 3 percent.  This works great and everyone is happy, as long as the inflation estimate is accurate.  If the government underreports inflation, however, then the raise they give you isn’t enough to offset the increase in prices.

As you may have guessed, many people believe this is happening.  There have been several changes to how the government calculates inflation over the years, all of which have had the same affect: To reduce the reported inflation rate.  The current Consumer Price Index (CPI) is currently around 2%.  Using the methods in place prior to 1990, that number is closer to 6%.  Using the methodology in place prior to 1980, that number is closer to 9% (See chart below from shadowstats.com).

I don’t know about you, but when I reflect on my expenses over the last year—property taxes, groceries, cable bill, gas, health insurance—it’s fairly evident that they increased by more than 2%.  What if the actual rate of inflation is closer to 6%?  How will that affect a person receiving Social Security benefits?  It doesn’t take a genius to see that, if inflation is 6% and the government gives you a 2% raise, they have effectively cut your benefits by 4%.  If that same pattern repeats itself for 10 years, the purchasing power of your benefits will have been cut by about a third.  They are giving you more money, but that money buys less.

Warren Buffet And the Widow

All of this reminds me of a story that Warren Buffett once told about an elderly widow with a passbook savings account.

“The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5% passbook account whether she pays 100% income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5% inflation. Either way, she is “taxed” in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120% income tax, but doesn’t seem to notice that 6% inflation is the economic equivalent.  If my inflation assumption is close to correct, disappointing results will occur not because the market falls, but in spite of the fact that the market rises.”

Applying that same logic to Social Security, we would find it outrageous if the government cut our Social Security benefits, but seem not to notice that inaccurate cost of living adjustments are the economic equivalent.  Disappointing results will happen not because the government cuts our Social Security benefits, but in spite of the fact that they raise them.

The Solution

The best way to overcome this hurdle is to build your own inflation factor into your Social Security benefits.  How do you do that?  Rather than waiting until full retirement age or later, the average person retires at 62 and takes a roughly 20 percent permanent reduction in benefits.  Rather than following their lead, if you wait a few years you can retire on full benefits.  Even better, retire a few years “late” and you can add as much as a third to your annual benefit (8 percent per year for those born after 1943 to a maximum age of 70).  The annual cost of living adjustment will likely still be understated, but it will be based on a much higher benefit amount.

Before signing off, I just wanted to make clear that I’m not so much criticizing the Social Security Administration as I am the methodology for calculating inflation.  As government agencies go, I’ve always felt that the SSA does a good job with the difficult task that they’ve been given.  I know that several people who work for the agency read this blog.  If you’re one of them, I’d love to hear your thoughts (pro, con or otherwise) on today’s post so we can all understand this issue better.    Just leave a comment at the bottom of the post.

Thanks and have a great week.

Joe