How are Social Security benefits funded and how is COLA calculated?

Social Security was created in 1935 and over the years the program has expanded in scope and been modified to ensure not only its viability but also that benefits don’t lose purchasing power. To make sure that monthly checks can keep up with inflation, starting in 1975 Congress mandated that every year benefit amounts would be automatically adjusted.

The cost-of-living adjustment (COLA) recently announced for 2023 is the fourth largest increase since the automatic annual boost to payments was implemented. While the 8.7% increase will give beneficiaries more breathing space as they deal with rising prices, it could put more strain on the solvency of the program. So how is the program financed and where does the COLA calculation come from.

How is the COLA calculated?

The SSA calculates the annual cost-of-living adjustment based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). Put together by the BLS, the CPI-W is a broad measure of how the cost of goods and services changes over time.

By comparing the CPI-W in the third quarters (July, August and September) of the current and previous year, the SSA determines how much benefits need to increase by in the coming 12 months to avoid falling behind the rate of inflation.

The COLA is the percentage by which the two CPI-W figures differ. In 2022, the CPI-W for Q3 was 291.901, while in the same period in 2021 it was 268.421: a difference of 8.7%.

How are Social Security benefits funded?

Funding for the SSA’s programmes comes from payroll tax deductions from working people in the US. The payroll tax rate for Social Security is 6.2%, meaning that both the employee and the employer must contribute 6.2% of the worker’s salary to the SSA to fund the programs. If you’re self-employed you have to cover the whole 12.4%.

The system is designed to run with a rolling surplus in the Social Security Trust Fund, a reserve of money that ensures that the payments can continue through fluctuations in the labor market. However, in recent years that excess has been drained by the growing number of Social Security claimants and was recently projected to run dry by 2035.

8.7% COLA could speed up Social Security insolvency by one year

The projection that the Social Security fund would be insolvent in 13 years was based on an estimated 3.8% COLA for 2023. The one announced was over twice as much which will add tens of billions of dollars to payment obligations causing experts to worry that it will accelerate the depletion of the program’s primary trust fund.

The Committee for a Responsible Federal Budget estimates that the increased costs could move that date up one calendar year. Several factors will play into any new projections going forward like immigration and the mortality rate. But one thing that is not contested is the need to reform Social Security to guarantee its solvency down the road.

Proposals to reform Social Security

There are efforts in place to secure the future of Social Security payments but they have yet to gain much traction in Congress. US Representative John Larson of Connecticut has proposed a package known as Social Security 2100: A Sacred Trust, which aims to expand upon and boost the funding of Social Security.

The bill which aims to shore up Social Security’s 75-year shortfall has over 200 co-sponsors in Congress. However, the bill, a newer version of one he introduced in the 116th Congress, would fall short of its goals according to the Center on Budget and Policy Priorities. Instead of keeping the program fully financed for 75 years and beyond, it would only extend its solvency for an additional four years by the progressive American think tank’s estimates.