The Center for Retirement Research at Boston College in a publication titled “The Impact of Inflation on Social Security Benefits” by Alicia H. Munnell and Dan Muldoon, is about Social Security and the recent announcement that benefits payable in December 2008 increasing 5.8 percent beginning January 1, 2009.

The 5.8 percent cost-of-living-adjustment (COLA) – the largest in 26 years – is an important reminder that keeping pace with inflation is one of the attributes that makes Social Security benefits such a unique source of income. (The other is that the payments continue for life.)

Higher inflation raises two other issues, however, that diminish the impact of the COLA. The first issue pertains to Medicare Part B premiums, deducted automatically from Social Security benefits. To the extent that premium costs rise faster than the COLA, the net benefit will not keep pace with inflation. Historically, premiums have gone up much faster than the COLA, although this year is an exception as premiums for 2009 will be unchanged from their current level. The second issue pertains to taxation under the personal income tax. Because the thresholds ($25,000 for single taxpayers and $32,000 for joint returns) above which taxes are levied are not adjusted for wage growth or even for inflation, rising benefit levels mean that taxation reaches further and further down the income distribution.

The brief explores the interaction of inflation and Social Security benefits. The first section describes the nature of the cost-ofliving adjustment. The second section looks at the interaction of Medicare premiums and the cost-of-living adjustment. The third section explores how inflation affects the taxation of benefits. The final section concludes the study.

The overall finding is that, while the inflation adjustment in Social Security is extremely valuable, the rise in Medicare premiums and the extension of taxation under the personal income tax mitigate the ability of beneficiaries to maintain their purchasing power. This erosion of retiree purchasing power is serious given that virtually all other sources of retirement income have no inflation protection at all.

In the future, without the protective legislation in place, benefits would actually decrease for many after retirement. With the protective legislation, the nominal benefits remain at least constant, but their purchasing power will erode by inflation.

A personal income tax with unindexed thresholds for benefit taxation means that wage growth and inflation will subject an increasing portion of the income distribution to taxation. Taxation further reduces the net benefit that people will receive. In short, even Social Security does not fully insulate older households from the erosive impact of inflation and this is a serious concern given that other sources of retirement income offer virtually no inflation protection.

The full study can is available on the Internet at: http://crr.bc.edu/images/stories/ib_8-15.pdf