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Last month featured the most important announcement of the year for Social Security's nearly 64 million beneficiaries -- namely, the annual release of the program's cost-of-living adjustment (COLA), which comes out during the second week of October each year.

As announced by the Social Security Administration (SSA), beneficiaries will see a 1.6% increase in their payouts in 2020. Based on the average retired worker's monthly payout of $1,475 in September, this equates to a $24 a month "raise" come January.

A roughly $288 annual increase in benefits probably doesn't sound too bad, but when you look at the history of Social Security's COLA, you'll see that looks can be deceiving.

Image source: Getty Images.

A little background on how Social Security's COLA is calculated

Since 1975, Social Security's COLA has been determined by changes in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). This is an inflationary index with eight major spending categories and dozens upon dozens of subcategories, all of which have various weightings.

In layman's terms, this index measures the change in price of a predetermined basket of goods and services. The weightings for each category and subcategory then come into play, producing a single figure that can be used to determine whether or not inflation (i.e., the rising price of goods and services) is present.

When calculating Social Security's COLA, only the CPI-W readings from the third quarter (July through September) are taken into account. While the other nine months of CPI-W readings can be useful for identifying inflationary trends, they have no bearing on Social Security's COLA.

Over the past 45 years, the average third-quarter CPI-W reading has risen 42 times. This is a roundabout way of saying that in 42 out of the past 45 years, Social Security's beneficiaries have received a "raise" that's commensurate with the year-over-year percentage increase (rounded to the nearest tenth of a percent).

Meanwhile, in the three years where the CPI-W readings dropped from one year to the next, thereby signaling deflation, benefits remained static. Thankfully, Social Security payouts cannot decline in the event of deflation.

Image source: Getty Images.

Where does Social Security's 2020 COLA rank in the grand scheme of things?

Now that you have a better understanding of how the SSA determines COLA from one year to the next, let's take a closer look at where the 1.6% COLA ranks, historically.

Over the past decade, it's really not been a terrible payout hike for recipients. Those aforementioned three years where no COLA was passed along occurred in 2010, 2011, and 2016. Furthermore, the smallest positive COLA on record -- a 0.3% payout increase -- was passed along in 2017. Thus, over the past decade, the average annual COLA has only been 1.4%. On a relatively short-term basis, a 1.6% payout increase is a hair better than par.

But if we use the binoculars to look out a bit further, things get really depressing, really fast.

Since 1975, there haven't been too many instances where COLA has been 1.6% or lower. With the exception of 1986 (1.3%), 1998 (1.3%), and 2002 (1.4%), six of the nine smallest COLAs in history have occurred since 2010. This makes the 2020 COLA of 1.6% the ninth-lowest in the 45-year history of the CPI-W, which is the program's inflationary tether. Not good.

Understand, however, that COLA is not designed to help beneficiaries get ahead. That is, it's not a "raise" in the traditional sense of the word. Rather, it's an upward adjustment designed to account for the inflation that program recipients are facing. Therefore, a higher COLA does mean a bigger payout, but it probably also means that beneficiaries are dealing with higher expenses, too.

Image source: Getty Images.

The verdict? Seniors are getting hosed by Social Security's COLA

Ultimately, regardless of whether or not the COLA is paid to beneficiaries, the consensus is that the CPI-W is doing a pretty poor job, and senior citizens are paying the price. Remember, seniors make up more than 4 out of 5 Social Security beneficiaries.

As the official name of the CPI-W states, it's an index that tracks the spending habits of urban and clerical workers. The problem is that urban and clerical workers spend their money very differently than seniors, and in many cases, they aren't even receiving a Social Security benefit themselves. A comparison of the CPI-W and the experimental Consumer Price Index for the Elderly (CPI-E) -- an index that measures the spending habits of households with persons aged 62 and over -- by the Bureau of Labor Statistics in Dec. 2011 showed some striking differences.

For example, the CPI-E shows that seniors spend twice as much of their monthly budget on medical care than urban and clerical workers. Seniors also spend a noticeable amount more on housing as a percentage of total expenditures than urban and clerical workers. The end result is that the CPI-W tends to underweight the most important expenditures for seniors while giving added weight to less-important costs, such as education, apparel, and transportation.

According to an analysis by The Senior Citizens League, a nonpartisan group that promotes the rights and benefits of seniors and retirees, the purchasing power of Social Security dollars for seniors has declined by 33% since 2000 and 18% over the past decade.

In other words, Social Security's COLA tether is a failure, and a 1.6% COLA isn't doing retired workers any favors in 2020.

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