One of Social Security’s most anticipated days has just passed: the announcement of the cost of living adjustment (COLA) for next year. If you’re wondering why retirees tend to circle the COLA announcement date on their calendar, look no further than the prices of everyday items.

People don’t usually start clapping when they hear the word “inflation“, but it is a necessary evil for a healthy, growing economy and much better than the alternative, deflation. That said, inflation has real effects on ordinary people because it decreases their purchasing power.

Inflation is especially noticeable for people on fixed incomes, like many Social Security recipients. To help offset this, Social Security applies a COLA. For 2025, the The COLA will be 2.5%and while I’m sure retirees appreciate any increase in benefits, many aren’t jumping for joy at the amount.

Image source: Getty Images.

How Social Security determines the annual COLA

The annual COLA is determined using the Consumer Price Index for urban employees and office workers (CPI-W). This is a monthly measure that tracks changes in the prices of common goods and services purchased by people who earn most of their money through office or hourly jobs in urban areas. This represents approximately 30% of the American population. Common items included in the measure are groceries, transportation, housing, clothing and typical household items.

Social Security averages the CPI-W figures from the third quarter (July, August, and September), compares the average to the previous year’s figures, and uses the difference to set the COLA. For example, if the third quarter CPI-W is 5% higher than the previous year, the COLA will be set at 5%.

Here are the CPI-W figures for the third quarter and the COLA for the following year:

Data source: Social Security Administration.

The increase from 301.236 to 308.729 is approximately 2.49%, which is how we get the 2.5% COLA for 2025.

If this year’s figure had been lower than last year’s, the monthly benefits would have remained the same. Social Security never decreases monthly benefits due to a decline in CPI-W numbers.

Why this year’s COLA is a double-edged sword

I view the COLA as a double-edged sword because, on the one hand, an increase is better than nothing. It’s been three years since there was a COLA, so having something is a positive. On the other hand, many retirees would agree that the modest 2.5% COLA won’t quite cancel out the price increases they’re experiencing.

According to the Senior Citizens League (an advocacy group for seniors), retirees’ spending power has declined 20 percent since 2010. That means $1,000 back then is worth about $800 today. Needless to say, this is not ideal.

One expense in particular that I like to focus on is medical bills, as health care is typically one of the largest expenses faced by seniors and retirees. The following table shows the increase in medical costs for people with individual insurance compared to that year’s COLA.

Data source: PwC Health Research Institute and Social Security Administration.

Medical expenses are just one example, but other expenses convey the same message. A COLA is nice, but it’s often not enough to negate inflation to 1:1, which should be the ultimate goal if adjusting to the rising cost of living in many regions.

It remains to be seen whether Social Security will eventually change its method of determining the COLA, but in the meantime, beneficiaries can begin planning their finances for 2025 by incorporating the incoming 2.5% increase.