In the explosion of speculation about the fiscal negotiations in Washington, one topic keeps surfacing: Is it time for the government to update its inflation measure to a "chained" Consumer Price Index? Let's take a look to see how this somewhat wonky decision could impact your financial planning if adopted immediately or perhaps more likely in the coming months.
The Consumer Price Index (CPI), is the best proxy we have for estimating and tracking inflation, and therefore changes in the cost of living. While not a perfect measure, it is very important for government policy and individual planning. For example, many benefit streams, including Social Security benefits, are indexed to inflation, thus making the quality of the inflation indexing calculation an important financial planning concern.
Social Security provides at least half of the income for the majority of its recipients and so is a fundamental component of lifetime financial security for a large part of our population. Before 1975, Social Security benefits rose only when Congress decided to give recipients a raise. However, starting in 1975, Social Security benefits by law became indexed to inflation and in particular to the Bureau of Labor Statistics' Consumer Price Index for Urban Wage Earners (CPI-W), with the caveat that benefits would never decrease from year to year. In periods of negligible or negative inflation, Social Security benefits remain constant. As inflation reheats after a period of deflation, benefits rise once the price index reaches its previous highest level. As a result, there is a nice History of Automatic Cost-of-Living Adjustments for Social Security benefits since 1975 using the CPI-W price index to calculate the annual cost-of-living adjustments.
Economists note, however, that CPI-W likely overstates the actual increases in cost-of-living because it reflects price changes for a fairly static representative basket of goods. CPI-W does not incorporate the fact that people change their purchasing behavior in response to changes in relative prices. For example, if prices of apples rise strongly relative to the price of oranges, most consumers will take note and buy relatively more oranges. Because of this substitution effect, their cost-of-living will not increase by the full amount of the price increase for apples. A relatively new "chained" Consumer Price Index (C-CPI-U) from the Bureau of Labor Statistics incorporates this very human tendency to adapt to new information, and so in the academic world the C-CPI-U is generally deemed to provide a more accurate measure of inflation.
In the political world, chained CPI is seen with some powerful emotions. For example, if the government switches to the chained CPI inflation measure, Social Security and other inflation-indexed government benefits will rise more slowly. The Social Security Administration estimates that chained CPI indexing would reduce its annual cost-of-living (COLA) adjustments by about 0.3% per year. Thus, the 1.7% scheduled increase in Social Security benefits for 2013 would have been instead about 1.4%. To put this information in context, in 2012 the average Social Security monthy benefit for retired workers was $1240 per month. This benefit would rise $21 in 2013 under the current indexing method and by $17 with chained CPI indexing. In other words, Social Security benefits would not be cut; they would grow more slowly, starting gradually and then over time adding up to an amount substantial enough to lengthen the estimated period of Social Security solvency by several years. Advocates applaud the improved accuracy of chained CPI indexing for inflation measurement and also the gradual decrease in government spending that its proposed adoption implies.
There are, however, important equity issues. Since lower income people are more dependent on Social Security income, inflation indexing with chained CPI is seen as hurting disproportionately those with lower incomes. Plus, it is not always true that people can easily substitute goods and services as relative prices change. In particular, the very old are seen as less able to substitute goods and services for several expenditures that, especially in lower income groups, may be the larger budget items, e.g. housing and health care expenses.
If chained CPI is incorporated into the tax code, taxes will increase, especially for middle income tax payers. For example, if the limits for tax brackets rise more slowly, a shift into a higher tax bracket becomes more likely if you are not already in the highest tax bracket. Similarly, exemption and deduction limits that grow more slowly would create higher taxes, including a larger percentage increase in taxes for middle income tax payers than for the very wealthy. Chained inflation indexing applied to retirement contribution limits would slightly reduce the amounts people can save in tax-sheltered accounts.
For its advocates, chained CPI indexing has the potential to "bend" the cost curve for government benefits and gradually increase tax revenues at a definitive but gradual pace. Those opposed focus more strongly on the unresolved equity issues.
The public policy conversation about chained CPI thus starts with its presumed ability to more accurately measure inflation, and then moves on to the gradual favorable impact its adoption could have on government finances by slowing benefits and increasing tax revenues. Very rapidly, however, the conversation shifts to important equity issues, leading to the intense fiscal negotiations currently underway about various proposed provisions designed to protect the lower and middle classes if chained CPI is adopted, e.g. by exempting Supplemental Security Income (SSI), a benefit program for the elderly poor, disabled, and blind, and/or by initiating a targeted increase in Social Security benefits.
Both political sides seem now to be talking more about their preferred implementation of chained CPI than just about its pros and cons, suggesting that chained CPI is coming our way in one form or another. As with any change in law and regulation, if chained CPI is implemented it will be important to understand the fine print.
An interesting nuance to consider is what the impact would be in the commercial world if chained CPI is adopted by the government as the standard measure of inflation. Will current owners of inflation-indexed immediate income annuities enjoy a possible grandfathering of their currently non-chained inflation-indexing? How about owners of long term care insurance contracts that include benefits linked to a non-chained CPI? Only time—and a close reading of the fine print—will tell.