The Social Security Annual Cost of Living Adjustment, or COLA, is one of the most important features of the government program. Without these annual increases, seniors would quickly find that the purchasing power of their monthly annuity checks would not meet their needs. For some, that could even be the case with COLA.
The Social Security Administration announced a 2.5% COLA for 2025 on October 10 of this year. That number is much lower than in recent years. Over the past three years there have been COLAs of 5.9%, 8.7% and 3.2% while inflation soared. But many seniors are still feeling the effects of inflation, and a 2.5% increase in their benefits won’t make much of a difference to their grocery bill.
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But there is a surprising benefit to a lower COLA for many seniors, and it could be much more important than the increase in their Social Security check.
Social Security was never intended to replace your income in retirement. When the program first started, many companies offered pensions to employees. Now most people have private pension savings. Social Security is intended to supplement the income of your retirees
t savings.
If you saved even a small amount in your 401(k) or IRA while working, you probably have a nest egg you can count on in retirement. Your retirement account doesn’t get a COLA – it gets the return the market offers. Over the long term, investors can expect a balanced stock portfolio to outperform inflation. But there is a lot of volatility that comes from investing in many securities.
It’s up to retirees to withdraw enough from their retirement accounts to cover their living expenses, no matter how much their investments have risen (or fallen). Theoretically, the purchasing power of social security will remain the same year after year. But the purchasing power of your pension portfolio will be greater in periods of low inflation compared to high inflation, all things being equal.
So retirees who have invested significant amounts of money in the market and who use savings to finance a significant portion of their expenses are actually better off in a low inflation, low COLA spending environment. It looks like we’re heading in that direction with the 2.5% increase in 2025.
Another reason why many seniors should be happy with the lower COLA is the long-term effect of inflation (the factor that determines your COLA) on retirement account withdrawals.
Many people use a safe withdrawal rate to determine how much they can withdraw from their retirement savings each year. For example, if you use the 4% rule, you will withdraw 4% of your initial portfolio balance from the time you retire. If you retire with $500,000 in savings, you will withdraw $20,000 per year. The key is to adjust that withdrawal every year for inflation. So if inflation was 5% this year, you would withdraw $21,000 next year. You keep adjusting every year.
Extended periods of high inflation can completely ruin your secure withdrawal rate plan. The father of the 4% rule, Bill Bengen, said the biggest threat is inflation, not a bear market or a bad run of returns.
We have had several years of relatively high inflation, and it is only now starting to come down. If inflation had continued to rise high into 2024, it would have led to a higher COLA, but it could have put serious pressure on many retirees’ withdrawal rates. If retirees are required to adjust their withdrawals lower to ensure the longevity of their portfolios, this could have a much greater impact for many than a higher COLA.
While many retirees may be disappointed by last month’s news, the upside is that the rest of their finances are looking much stronger as a result of low inflation.
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The disappointing 2025 Social Security COLA could benefit a surprising number of retirees was originally published by The Motley Fool
