Social Security has long been considered one leg of the “three-legged stool” of retirement planning. The other two being employer pensions and personal savings. However, employer pensions are quickly vanishing, and personal savings rates generally remain far too low to make up the difference. Of course, this amplifies the importance of Social Security as part of your retirement cash flow.
The significance of Social Security in retirement planning is often overlooked or undervalued. Younger generations assume that it will cease to exist before they reach retirement age, and wealthier families underestimate the value of the monthly benefits. However, in the context of retirement planning, Social Security represents an inflation adjusted, lifetime annuity, backed by the federal government. In other words, it’s a big deal.
Of course, an important part of that deal is the inflation adjustments. Benefits were recently announced to increase 2.0% beginning in January 2018, the largest cost of living adjustment (COLA) since 2012. In fact, this follows inflation adjustments of just 0.3% this year, and no increase at all in 2016.
Before you start planning how you will spend the additional income, consider that the increase might be partially or fully offset by an increase in Medicare premiums, which will be announced later this year.
How it works if you delayed benefits
Here’s a common question about Social Security COLA increases: since I delayed receiving my Social Security benefits until age 70, am I missing out on the inflation adjustments until then?
There’s good news here. You get the inflation adjustment even if you have chosen to delay benefits. Technically, here’s how it works. Your total benefit at normal retirement age (age 66 if you were born between 1943-1954) is called your Primary Insurance Amount (PIA). When you delay benefits, your benefit amount increases 8% per year (uncompounded) until age 70. So, if your Normal Retirement Age (NRA) is 66 and you wait until age 70 to begin receiving benefits, your benefit will be 132% of your PIA. The COLA is applied to your PIA beginning in the year in which you are eligible to receive benefits (age 62), meaning that you will actually receive 132% of your inflation adjustment PIA.
Simple, right? Of course not, it’s Social Security. What did you expect?
Here’s an example that might help. For this example, we’ll assume that inflation is 2% every year.
Let’s say Anna was expecting a benefit of $2,500 at age 66, her normal retirement age. If she chooses to begin benefits at age 62, she will receive a reduced monthly payment of $1,875. By age 66, after four years of 2% COLA, her monthly check would be $2,030. By age 70, after four more years of inflation adjustments, she would be receiving $2,197 per month.
Instead, if she began benefits at age 66, her first check would be $2,706, and at age 70, she would receive $2,929 per month.
If Anna chooses to delay Social Security retirement benefits until at 70 in order to receive that largest possible amount, her benefits would begin at $3,866.
The important takeaway here is to remember that you are receiving the benefit of the inflation adjustment from the time you reach age 62, whether or not you are receiving your Social Security income. Also, by delaying Social Security, future inflation adjustments are applied to your larger benefit amount. This means that each inflation adjustment will be a larger dollar increase than if you began benefits early.