Social Security COLA ‘Click Bait’

Over the past couple of years, one of the most-clicked posts on NAPA-Net has been on a topic that is a bit of a head-scratcher.

I’m speaking, of course, of the (now-incessantly tracked), monthly projections of the (potential) cost of living adjustment (COLA) for Social Security. It started back when inflation emerged as a real consumer concern—and it was spurred by the efforts of a group called the Senior Citizens League in publishing—EVERY MONTH—a projected cost of living adjustment (COLA) for Social Security.[i] And our coverage of those projections has been, and continues to be, one of the most clicked-on stories[ii] (ditto other publications, apparently).  

Like many, perhaps most, of you, I was initially intrigued by the reporting. Let’s face it, after a couple of decades of relative economic slumber, inflation has reared its ugly head in a way that reminds some of us of the days of our youth when inflation was an actual scary economic reality, rather than an obscure concept. And, at a time when the soaring cost of—well, everything—has (re)garnered our attentions, the notion that those impacts for older workers might be muted by a positive adjustment in their monthly benefit (not to mention those prospective increases in contribution and benefit limits of qualified plans) was encouraging.

But every single month?        

Not that Social Security has always had a COLA. In fact, Congress enacted the COLA provision as part of the 1972 Social Security Amendments, and automatic annual COLAs didn’t begin until 1975. Prior to that, benefits were increased only when Congress enacted special legislation. As for its calculation, Social Security’s COLA is based on the percentage increase in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) from the third quarter of the last year a COLA was determined to the third quarter of the current year. If there is no increase—and, believe it or not, that’s been the case in recent memory—there can be no COLA. That said, you can imagine that there tends to be something of a hue-and-cry from Social Security beneficiaries in those rare situations (most recently in 2016,[iii] though the increase in 2017 was just 0.3%). 

Of course, inflation measures often seem to be as much art as science—varying largely on what you spend your money on—and seniors do tend to spend money differently. In fact, one of the criticisms of the current formula is that it considers the purchases that current workers make, rather than retirees.[iv]  Another factor is the timing of the formula, which considers the period from September of one year to the next—while the government reports tend to reference the change from the PRIOR month, or in some cases from the same month a year earlier. 

That said, those on what are commonly referred to as “fixed incomes”[v] are understandably interested (and anxious) about potential increases (or lack thereof) in those finances. Let’s face it—retirement is not a profession that warrants merit increases, after all, nor are there typically opportunities for “promotion.” Purely from an SEO perspective, one can understand and appreciate the internet search engines cranking up to try and get a peek at what’s coming up in terms of potential benefit increases (and, to be sure, we do get significant traffic for those posts outside of our newsletter distribution). Still, and while those projections are based on the realities of the official inflation numbers reported by the federal government, they are merely point-in-time guestimates when it comes to knowing what the actual COLA number will be.

Not that I don’t “get” and appreciate the significance of the ACTUAL Social Security COLA—its impact on retirement projections, not to mention realities, is significant. That said, relentlessly tracking the POTENTIAL COLA based on interim monthly readings of inflation a year out from the actual establishment of the COLA have always struck me as a bit… obsessive. But clicks drive coverage these days and for the foreseeable future, and therefore, as long as you (all) keep clicking, we’ll keep covering…

Still, it should serve as a reminder to us all that planning for retirement should look beyond the income we happen to be drawing when we leave the workforce. After all, if the income we have at retirement isn’t enough to adjust to the costs of living in retirement—it might well cost us an “adjustment” in how, or how well, we live through retirement.

- Nevin E. Adams, JD

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[i] According to their website, they are a nonpartisan seniors group, and have been since 1992, though it wasn’t until the COLA adjustment reports that they crept onto my radar. And perhaps that, as much as anything else, explains the monthly COLA reports.

[ii] And by including “Social Security” in the title of this post, I’m shamelessly trolling for some additional SEO visibility, of course.

[iii] You can find a table of the COLA at https://www.ssa.gov/cola/

[iv] For more details, check out http://assets.aarp.org/rgcenter/ppi/econ-sec/fs160.pdf or https://www.aarp.org/retirement/social-security/info-2020/colas-history.html.

[v] And it’s not just retirees. Disabled workers and their dependents account for 19% of total benefits paid, according to the Social Security Administration (see http://www.socialsecurity.gov/pressoffice/basicfact.htm).

 

(A Little More) Room to Grow

 Several years ago, we had in mind that it would be fun to get an aquarium for our home, and (even) I got excited at the prospects of filling it with a variety of all kinds and sizes of exotic fish. 

Sadly, those hopes were dashed when I discovered that , despite the massive displays of what appeared to be whole schools of fish in similarly sized tanks at the pet store, our specific-sized tank would only support a handful of the fish I had hoped to display. Apparently, the more fish you want to have (that live), the bigger the tank you need. The reason: they need room to thrive and grow.

At long last the IRS last week announced the new contribution and benefit limits for 2022. Considering the run-up in inflation this year, expectations were similarly high for increases in those limits. And sure enough, among other things, the 401(k) limit was bumped $1,000 (to $20,500) and the defined benefit plan limit rose from $230,000 to $245,000, though the limit for catch-up contribution held level at $6,500. 

At the outset, it’s worth remembering that these adjustments only reflect increases in the cost of living—basically an acknowledgement that the costs of living in retirement change over time, that they increase due to inflation—and that they are timed in such a way that those increases must accumulate to a certain level before that acknowledgement in the form of increased levels kicks in.

But since industry surveys[i] suggest that “only” about 9%-12% currently contribute to those levels, does it matter? And why don’t more people max out on those contributions? Well, cynics might say it’s because only the wealthy can afford to set aside that much.[ii] But Vanguard’s data suggests that only about half (56%) of even those workers making more than $150,000 a year maxed out their contributions. If these limits and incentives work only to the advantage of the well-off, why aren’t more maxing out?

Limit ‘Ed’

Those who look only at the outside of the current tax incentives generally gloss over the reality that there are a whole series of benefit/contribution limits and nondiscrimination test requirements. These rules are, by their very design, intended to maintain a balance between the benefits that these programs provide between more highly compensated individuals and the rest of the plan participants (those rules also help to ensure a broad-based eligibility for these programs). Almost assuredly those limits are working to cap the contributions of individuals who would certainly like to put more aside, if the combination of laws and limits allowed.[iii]

But let’s think for a minute about a group that doesn’t get nearly enough attention: the group— millions of working Americans, in fact—who are not wealthy by any objective measure, but earn enough that Social Security won’t come close to replicating their pre-retirement income. These middle and upper-middle income individuals apparently aren’t the concern of those who want to do away with the 401(k)—but these are the individuals who in many, if not most, situations, not only make the decision to sponsor these plans in the first place—they make the ongoing financial commit to make an employer match.

If nothing else, allowing those contribution limits to keep pace with inflation—like the right-sized aquarium—provides us all not only with a little more room to grow our retirement savings—but reminds us (all) of the opportunity to do so.

- Nevin E. Adams, JD

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[i] According to Vanguard, during 2020, 12% of participants saved the statutory maximum dollar amount of $19,500 ($26,000 for participants age 50 or older). Fifty-six percent of participants with an income of more than $150,000 contributed the maximum allowed. 

[ii] Setting aside for a minute that $20,000/year likely won’t make much of a dent in the replacement rate for a wealthy individual.

[iii] For some additional validation of the impact of these limits, see “Upside” Potential.

Tax Reform – ‘Tricks’ or Treat?

A few weeks back, my wife and I went to see the updated version of It. Now, I’ve been a fan of King’s work ever since a friend shared a copy of Salem’s Lot with me, though his work doesn’t always translate as well to the big screen. “It” is a malevolent entity that emerges about once every 27 years to feed, during which period it takes on various shapes designed to lure its prey – generally children, and then it returns to a hibernation of sorts. “It”’s most notorious incarnation is, of course, Pennywise the Dancing Clown (the lovely visage below).

Ironically, tax reform too seems to be a once-in-a-generational thing. It’s been 30 years since the Tax Reform of 1986 cut tax rates1 – and cut into retirement plan saving and formation with the creation of the 402(g) limit (and its tepid COLA pace), not to mention the cost and timing issues associated with multiple iterations of the nondiscrimination testing that often produced problematic refunds for the highly compensated group. There’s little question that those changes (and others) did what they were designed to do – generate additional tax revenue by limiting the deferral of taxes. But what did those constraints do for retirement security?

Much of that damage wasn’t repaired until – well, 2001 with the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) – which, somewhat ironically, introduced the concept of the Roth 401(k).

Rothification Response

While tax reform has wrought its damage on retirement savings before, this time around a new way to raise revenue has emerged – “Rothification,” loosely defined as the limiting or elimination of the current pre-tax contribution limits.

We don’t really know what workers would do confronted with that kind of change (the surveys that are available – though not completely on point suggest that the response might be modest) – though we do know that if current participants continued to save at the same rate, retirement readiness would likely improve. There are also signs that it would be seen as a big enough change that some, perhaps many, plan sponsors would want to rethink, if not reconsider, their current automatic enrollment assumptions.

We may not know with certainty those outcomes, but there are lots of reasons to be nervous, if not downright fearful of change to retirement plans, particularly one that seems likely to give plan sponsors – and plan participants – a reason to rethink their current savings rates. Granted, surveys show that most plans already offer a Roth option, and more recent surveys indicate that most plan sponsors would continue to offer a plan even if the current pre-tax option for 401(k)s was reduced and/or eliminated (and how sad would it be if a plan sponsor decided to walk away from offering a plan just because the pre-tax savings option was clipped).

We also know that more than half of current 401(k) contributors would be affected by a $2,400 pre-tax contribution limit, based on data from the non-partisan Employee Benefit Research Institute (EBRI), using their Retirement Security Projection Model® (based on information from millions of administrative records from 401(k) recordkeepers), and that the impact reaches down to some very moderate income levels.

That said, we don’t yet know – and this is significant – if the tax reform proposals that emerge this month will include some version of Rothification, nor at what level the Rothification restriction might be imposed (as it turns out, Rothification was NOT included in this first round!).

‘Pass’ Tense?

Consider the recent “unintended” consequence of a proposed tax break for pass-through entities (i.e., partnerships, S corps, and small business limited liability corporations). More than 320,000 of these entities sponsor a retirement plan (with the average size being 75 employees) – unfortunately, many of these businesses may reconsider adopting or maintaining a qualified retirement plan because of significant financial disincentives woven into the fabric of the tax reform proposal, which would establish a 25% maximum pass-through rate on that business income, versus the 35% top rate on ordinary income (as well as the favorable tax rate on capital gains income at 20%) that would be assessed when the money is withdrawn at retirement. In other words, the small business owner’s plan contributions and accumulated earnings will be taxed at 35% instead of the 25% pass-through rate and the 20% capital gains rate on accumulated earnings.

There are some things about tax reform proposals that we do know. One, that lawmakers – and sometimes regulators – often seem to operate on the assumption that employers will, and indeed must, offer a workplace retirement plan no matter what changes or cost burdens are imposed on plan administration. With an eye toward narrowing the benefit gap between higher-paid and non-highly compensated workers, limits are imposed that often outweigh the modest financial incentives offered to businesses, particularly small businesses, to sponsor these programs. This, despite the striking coverage gap among those who work for these small businesses, and the potentially burdensome administrative requirements and additional costs that the owner must absorb, alongside a pervasive sense that their workers aren’t really interested in the benefit (or, perhaps more accurately, would prefer cold, hard cash).

The debates about modifying retirement plan tax preferences – or the notion that these preferences are “upside down,” and thus may be dispensed with – are bandied about as though those changes would have no impact at all on the calculus of those making the decisions to offer and support these programs with matching contributions. In other words, while some attempt is made to quantify the response of workers to changes in their incentives, most studies simply assume that employers will “suck it up.”

Well, this week the GOP is slated to unveil its proposal for tax reform in the House of Representatives, and shortly thereafter we should see a separate GOP proposal emerge in the Senate. Those will have to be reconciled, and these days that’s no slam dunk.

It remains to be see what tax reform – with all its laudable objectives – might mean for retirement plans this time around. But here’s hoping that, if tax reform turns out to be “Pennywise,” it won’t be “pound” foolish.

- Nevin E. Adams, JD

Footnote

1. And the time before that was 1954… with the creation of the Internal Revenue Code.

The Cost of Living

At a recent conference, our luncheon table got to talking about savings trends and the unique challenges of Millennials, specifically the impact of graduating with so much college debt.

While several at the table had graduated with (and since paid off) college debt, the sums paled in comparison to the kinds of figures bandied about in recent headlines — or did, until I loaded up an online calculator that allowed us to see what our college debt at graduation amounted to in today’s dollars. To the collective astonishment of the retirement experts at that table, the totals, adjusted for inflation, were very much in line with the figures reported for today’s graduates.

Factoring in those kinds of cost-of-living adjustments is, of course, a crucial aspect of retirement planning. Unlike Social Security, there is no annual cost-of-living “adjustment” for retirement savings—no systematic means by which those accumulated savings are increased to offset the increased costs of things like heating fuel, food and medicine. After all, managing to replace a targeted amount of preretirement income is of little consequence if, 10 years into retirement, that amount isn’t sufficient to provide for life’s necessities.

The bottom line is this: We’re well advised as savers to take into account the inevitable cost-of-living increases that occur over time, even in a period of low inflation. To their credit, most retirement savings calculators retain an inflation assumption that can help those future projections reflect potential realities (though you often have to provide that rate).

However, those adjustments are also often incorporated in a projected annual increase in pay (and deferral) that, for a significant number of American workers, may be little more than a quaint anachronism. Unfortunately, the cost of living moves on without our proactive involvement — unlike our rate of savings (in the absence of design changes such as contribution acceleration).  

Every generation has its own challenges, of course. And even if this newest generation of workers lacks the promise of a defined benefit pension (as noted previously, the realities of those promises were often something else altogether), a growing number will find themselves enrolled automatically upon hire and invested in a diversified asset allocation portfolio. Some will also find that their initial deferral is raised automatically each year.

Certainly the level of college debt is daunting for many, and may well dissuade some from saving for retirement, at least until some of that obligation is “retired” — as it did many of their parents.  Doubtless this newest generation of workplace savers feels that they are dealing with a set of extraordinary financial constraints, though those constraints may not be as unique as they may think once one takes the cost of living into account.

Not to mention the costs of living — in retirement.

- Nevin E. Adams, JD