Social Security began granting regular COLAs in the early 1970s, to maintain the purchasing power of Social Security benefits in the face of rising prices. Prior to 1972, Congress passed ad hoc benefit increases when necessary. COLAs are calculated using the Consumer Price Index for Urban Wage Earners and Clerical Workers, called the CPI-W. The Bureau of Labor Statistics tracks changes in the CPI-W from the third quarter of one year to the third quarter of the next, and benefits are adjusted beginning in the following January.
The BLS constructs the CPI-W by first tracking changes in the prices of everything from furniture and bedding to sugar and artificial sweeteners. The BLS then weights these price changes based upon how much households spend on particular items, using data from the Consumer Expenditure Survey. The change in the weighted average of these prices is the increase in the CPI, on which the COLA is based.
Except for homes, where the process is different. If you own a home you’re not spending directly on the home itself. Instead, the BLS calculates how much that home would rent for, and then adds that “implicit rent” to the other spending captured by the CPI. If home prices rise, then implicit rent rises and retirees are assumed to be “spending” more on housing.
Except they’re not. Only 17% of Americans age 65 and over rent their homes, with those costs making up less than 5% of total household outlays. The remaining 82% own their homes, and so they’re not paying that implicit rent. Rising home prices make retiree homeowners richer, but the CPI acts as if retirees are made poorer.
Source: Andrew Biggs