Anticipated 2025 Social Security Cost-of-Living Adjustment Falls Short, Potentially Favoring NumerousRetirees
The yearly adjustment to Social Security expenses, commonly known as the cost-of-living adjustment (COLA), is a significant aspect of this government program. Should this adjustment not occur annually, seniors might find that the purchasing power of their retirement checks no longer adequately covers their necessities. For some, this might feel like the case, even with the existence of the COLA.
On October 10 this year, the Social Security Administration declared a 2.5% COLA for 2025. However, this figure is significantly lower compared to the previous years, where COLAs of 5.9%, 8.7%, and 3.2% were observed due to the escalating inflation rates. Despite this, many seniors are still grappling with the impact of inflation, and a 2.5% increase in their benefits might not have a substantial impact on their grocery expenses.
Intriguingly, there exists a less apparent advantage to a lower COLA for numerous seniors. This benefit could be more significant than the increase in their Social Security checks.
The hidden benefit of a low COLA lies within your retirement savings
Originally, Social Security was not conceived as a sole income source during retirement. During its inception, numerous companies offered their employees retirement plans (pensions). Currently, most individuals rely on personal retirement savings, while Social Security serves as a supplement to income from these savings.
If you saved even a negligible sum in your 401(k) or IRA during your employment, you likely accumulated a nest egg you're currently withdrawing from in retirement. Unlike your retirement account, it does not benefit from the COLA; instead, it is influenced by market returns. Generally, a well-diversified portfolio of stocks may surpass inflation in the long run. Nonetheless, investing in various securities introduces a degree of volatility.
Retirees remain responsible for extracting enough from their retirement savings to cover their living expenses, regardless of how the market performs (be it up or down). Consequently, over prolonged periods of low inflation, the purchasing power of Social Security remains consistent. In contrast, the purchasing power of your retirement portfolio increases in low-inflation environments compared to high-inflation ones, all things considered.
Retirees with substantial investments in the market, who rely on these assets to fund a substantial portion of their spending, may actually be better off in a low-inflation, low-COLA environment. It appears this scenario is becoming more likely with the 2.5% rise in 2025.
Inflation's influence on the longevity of your retirement portfolio
Another reason why several seniors could appreciate the lower COLA is the long-term impact of inflation (which dictates the COLA) on retirement account withdrawals.
Many individuals follow a safe withdrawal rate to gauge their annual withdrawal from retirement savings. For instance, if you adhere to the 4% rule, you would withdraw 4% of your initial portfolio balance at retirement. If you retire with $500,000 in savings, you would withdraw $20,000 each year. The vital aspect is that this withdrawal will be adjusted for inflation every year. Hence, if inflation was 5% this year, you would withdraw $21,000 the following year. This process continues each year.
Long stretches of high inflation can disrupt your safe withdrawal rate strategy significantly. According to Bill Bengen, the creator of the 4% rule, inflation poses the greatest threat, not a bear market or poor sequence of returns.
We have been experiencing a series of relatively high inflation rates, which are now beginning to decrease. If inflation had persisted at elevated levels in 2024, it would have led to a higher COLA. However, it could have placed pressure on many retirees' withdrawal rates. If retirees are compelled to reduce their withdrawals to safeguard their portfolio's longevity, it could have a more substantial impact on them compared to the benefits arising from a higher COLA.
Though many retirees may have been disheartened by the news last month, there is a silver lining. As a consequence of low inflation, the rest of their financial situation appears to be in a stronger position.
In this low-COLA environment, seniors with substantial investments in the market might find their retirement portfolio's purchasing power increasing faster than the consistent Social Security benefits, as a well-diversified portfolio can often surpass inflation in the long run, despite market volatility.
Moreover, persistent low inflation can be beneficial for retirees following a safe withdrawal rate strategy, as it can help mitigate the impact of inflation on their retirement account withdrawals, potentially allowing them to maintain their spending levels without placing undue pressure on their portfolio.
