Why Inflation Matters For Social Security, Medicare And Your 401(k)

Despite the Federal Reserve’s assurances that it won’t last, high inflation has become one of the dominant stories of 2021.

Retired Americans living on fixed incomes have been struggling with rising prices, but people who are still working tend to fear inflation more. One reason for this is that retirees get an annual cost-of-living adjustment (COLA) to their Social Security checks. More inflation means a bigger COLA—benefits will increase by 5.9% in 2022, for instance, the biggest boost since 1982.

Still, inflation has plenty of downsides for retirees, like pricier Medicare B premiums. Meanwhile, the Fed is eager to ease off bond purchases before they ultimately raise interest rates in the years to come, which will likely have a negative impact on retirement investments.

“The real question for retirees is will this [COLA] increase be enough to offset the rising costs of goods, or will it just lessen the blow,” said Tim Steffen, director of tax planning at Baird.

Inflation and the Social Security COLA

More than 64 million Social Security beneficiaries will get higher benefits next year, according to the Social Security Administration, with the estimated monthly average benefit for retired individuals jumping to $1,657 from $1,565 in 2021. A typical retired couple who are both receiving benefits will now receive $2,753 compared to $2,599 this year.

“Indexing benefits to inflation aims to protect retirees’ buying power over time,” said Chantel Boyens, principal policy associate at the Urban Institute. “If you tried to buy this on the market, it would be very expensive.”

This isn’t the first time a large Social Security COLA has followed a troublesome financial year. The 2009 COLA was 5.8%, for instance, even as the Great Recession was still driving mass unemployment and financial havoc.

Why do these big gains arrive hand-in-hand with economic crises, you may wonder? It has to do with the data that’s used to determine the COLA, namely the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

This gauge, said Chief Actuary for the Social Security Administration Stephen Goss, is strongly influenced by gasoline prices. You’ll recall that a gallon of gas rose above $4 in 2008, according to U.S. Energy Information Administration (EIA) data. Meanwhile, gas prices have climbed to more than $3.27 as of September 2021 as social distancing mandates were relaxed, people drove more and supply chain disruptions impacted supply.

While retirees certainly had reasons to be happy with the big COLA hike in 2009, they were probably less than thrilled when there were no adjustments in 2010 or 2011 as gasoline costs flatlined or declined but the economy continued to struggle.

While no one can predict the future, seniors today shouldn’t expect 2022-like hikes to become the new normal.

Inflation and Medicare B Premiums

Some of the extra money from the Social Security COLA may also be eaten up by Medicare Part B premiums.

For those who enroll, Medicare Part B covers outpatient services and physician visits. The premiums are automatically deducted from monthly Social Security benefit checks, and it’s expected that costs for most retirees could rise by around $10 from $148.50 a month presently for those with less than $176,000 in income.

It’s important to remember that each person’s Social Security benefit varies, depending upon when they first filed for benefits and how much they earned throughout their lives. It’s possible that the total amount of your benefit is actually smaller than the typical benefit recipient because you’re starting from a lower base.

A small number of people may actually see their Medicare B premiums increase more than what they’d receive from their COLA. In these instances, the Medicare employs something called a “hold harmless provision,” which ensures that your Social Security check won’t decrease if you meet some basic eligibility requirements.

Inflation and Retirement Savings

One of the odd outcomes of the Covid recession is that investment portfolios have gone gangbusters. It’s widely agreed that the Fed’s easy money stance has greatly benefitted the stock market over recent years.

Average account balances at Vanguard, for instance, jumped by 21% in 2020 thanks mostly to an 18% increase in stocks.

The party may be over, however.

Fed chair Jerome Powell says that the central bank has made substantial progress towards its goal of achieving inflation moderately above its 2% target for some time. More recently, he’s hinted that the labor market has just about reached that threshold, too, which means the Fed could soon taper its $120 billion in monthly bond purchases.

With the Fed preparing to wind down its emergency measures and start coping with stubbornly high inflation, stocks—and your retirement savings—may be facing more headwinds.

While that’s a necessary step to eventually get back to a more normal central bank policy posture, it may result in choppy markets or even a market correction over the next few months. That’s why it’s a good idea for retirees to have about a year or more of expenses saved up in cash: You don’t want to be forced to sell in a down market to get much needed cash.