Rising prices have hammered the U.S. economy this year, as pandemic-era stimulus checks, supply chain problems, and geopolitical conflict have triggered the worst bout of inflation in four decades. That financial pressure has forced millions of Americans to dip into their savings to make ends meet, and the situation has been especially challenging for retired workers on Social Security. In fact, 85% of retired workers say rising prices are stretching their budgets, according to a recent survey from The Motley Fool.

On the bright side, Social Security beneficiaries will receive one of the largest cost-of-living adjustments (COLAs) in history next year, and that raise is looking a little better each month.

Here's what retirees should know.

Image source: Getty Images.

Social Security's COLA in 2022 underestimated inflation

Inflation causes money to lose value over time. For instance, $100 will buy fewer goods and services today than it did five years ago, and it will buy much less than it did five decades ago. In other words, the cost of living tends to get a little higher with each passing year, so an annual COLA is applied to Social Security benefits to offset that trend.

The Social Security Administration (SSA) calculates those COLAs by tracking changes in the third-quarter Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) from one year to the next. For example, the CPI-W increased 5.9% in the third quarter of 2021, so a 5.9% COLA was applied to Social Security benefits in 2022.

Unfortunately, that 5.9% COLA dramatically underestimated the pace of rising prices. In fact, annualized inflation has far exceeded 5.9% in every month this year, as illustrated in the chart below.

Data source: Bureau of Labor Statistics. Note: Inflation rate reflects the year-over-year change in the CPI-W.

Year to date, the CPI-W has increased by an average of 8.8%. That means the 5.9% COLA applied to benefits this year needed to be almost 3 full percentage points higher to completely offset the impact of inflation. That means Social Security benefits lost buying power in 2022, and that shortfall hit retired workers hard.

How big was the shortfall? The average benefit paid to retired workers was $1,657 per month in January 2022. But if the COLA had been 8.8%, the average benefit would have been $1,702 per month. That means the average retired worker should have received an extra $45 in monthly income from Social Security, meaning the shortfall was $540 for the full year.

Social Security's COLA in 2023 could overestimate inflation

Next year, Social Security benefits will get an 8.7% COLA, which ranks as the fourth-largest COLA in the history of the program. Beneficiaries haven't seen a raise that big since 1982. But the size of the COLA is irrelevant to some extent. What actually matters is how the COLA compares to inflation, and that comparison is looking better each month because inflation has been decelerating since it peaked in June.

Of course, there is no guarantee that trend will persist, so retired workers should continue to budget their money cautiously. But if inflation does indeed continue to slow, the 2023 COLA could overestimate the impact of rising prices in the same way the 2022 COLA underestimated the impact. That means Social Security benefits could regain some lost buying power next year, and that is good news for retired workers.