Inflation has slowed significantly since its peak in June 2022, but high prices remain a problem for many retirees. A recent survey from the Employee Benefit Research Institute, a nonpartisan research organization, found that 56 percent of retirees worry they will have to significantly cut their spending to keep up with inflation.

Social security benefits will benefit from a 2.5% cost of living adjustment (COLA) in 2025 to offset rising prices across the economy. This is the smallest increase for Social Security recipients since 2021, and most retirees view the increase as insufficient, according to a report. recent survey run by The Motley Fool.

“The COLA increase is not large enough to outweigh the growing costs faced by Social Security beneficiaries,” said Kevin Thomson, financial expert and CEO of 9i Capital Group. “This increase will likely be overshadowed by rising housing and medical costs over the past year.”

Here are the important details.

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Social Security benefits get a 2.5% cost-of-living adjustment (COLA) in 2025

Social Security beneficiaries receive an annual allowance cost of living adjustments (COLA) to protect the purchasing power of benefits by ensuring that payments increase at the same rate as inflation. The measure used to track inflation is a subset of the Consumer Price Indexknown as the CPI-W, also called the Consumer Price Index for Urban Wage Earners and Office Workers.

The calculation is simple: the average CPI-W reading for the third quarter of the current year (i.e. July to September) is divided by the equivalent reading from the previous year. The percentage increase then becomes the COLA the following year. For example, the CPI-W increased by 2.5% in the third quarter of 2024, meaning Social Security benefits will have a 2.5% COLA in 2025.

That means the average retired worker will receive $49 more per month, or $588 for the entire year, according to the Social Security Administration. Unfortunately, this pay increase comes with some bad news: It may not accurately reflect the pricing pressures retirees face, in which case benefits would lose their purchasing power next year.

Social Security benefits likely to lose purchasing power in 2025

The CPI-W tracks inflation based on the purchasing habits of young working-age adults. Some experts see this as a problem because these people spend their money differently than Social Security recipients. In other words, policy experts say it doesn’t make sense to calculate COLAs for retired workers based on how young adults spend their money.

The biggest concern is that retired workers typically spend more on housing and medical care and less on education and transportation, compared to younger workers. But the CPI-W is weighted according to the spending habits of young adults, so it naturally underestimates the importance of housing and medical care and overestimates the importance of education and transportation.

The Senior Citizens League, a nonprofit advocacy group, estimates that the disconnect has caused Social Security to lose 20 percent of its purchasing power since 2010. And the problem is likely to get worse next year. While the overall CPI-W rose 2.5% in the third quarter of 2024, prices in underestimated spending categories (housing and medical care) increased faster, while prices in overestimated categories ( education and transport) grew more slowly, as detailed below.

• Accommodation: 4.3%
• Medical care: 3.4%
• Education: 0.4%
• Transportation: (0.5%)

The Senior Citizens League and several politicians have proposed calculating COLAs using another subset of the Consumer Price Index called the CPI-E, or Consumer Price Index for Seniors. The CPI-E measures inflation based on the purchasing habits of individuals aged 62 and older, a group that more closely matches the portion of the population that receives Social Security benefits.

Importantly, the CPI-E rose 3% during the third quarter of 2024, outpacing the CPI-W by half a percentage point. In other words, Social Security beneficiaries would have received a 3% COLA if the wage increase had been based on CPI-E inflation. In this scenario, the average retired worker would have received $58 more per month in 2025, or $696 for the entire year.

This means that the COLA applied to Social Security benefits in 2025 is likely to be too low, which is another way of saying that Social Security is about to lose its purchasing power next year. Although some policymakers have proposed replacing the CPI-E with the CPI-W, this change is unlikely to pass Congress anytime soon. Social Security is already struggling with a multibillion-dollar funding gap, and larger COLAs would only make the problem worse.

On the bright side, retired workers looking for extra income next year have some good options. Interest rates are high, making certificates of deposit (CD) and high yield savings accounts attractive. And the stock market has reached all-time highs, making now a reasonable time to sell stocks.