Why Inflation's Higher Than It Looks

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Social SecurityLast fall, Social Security recipients got their first raise in their monthly benefit checks since 2009. Yet, if you're like most people, watching the prices of the things you buy go up all the time makes the government's inflation gauge seem out of touch.

But there's a good reason why the government's estimates don't match up with your experience: They aren't designed to.

Like any statistic, the Consumer Price Index, which measures inflation, is only as effective as the assumptions it makes -- in this case, about what you spend money on. If you spend more on certain things than most people, then the CPI will do a terrible job of reflecting the prices you actually pay.

Understanding the Consumer Price Index

The CPI looks at a "basket" of different types of goods and services that the Bureau of Labor Statistics thinks reflects the typical household's expenditures . The biggest category in the CPI is housing, which makes up 40% of the index. Food and transportation each contribute another 15%. The remaining amount is spread across recreational activities, education, health care, and other goods and services.

The BLS specifically says that the CPI won't match up with the experience of any specific individual. But because of the way it's constructed, many people will see some dramatic differences.

What It Means for Retirees

In particular, retirees often don't fit the CPI profile well at all. Many retirees have already paid off their mortgages, and despite still having to cover utility costs, property taxes, and maintenance and upkeep, their spending on their housing needs falls well short of 40%. And declining home prices have only benefited those who didn't own homes prior to the housing bust. Far from getting any benefit, retirees who own their homes have taken big hits to their finances.

At the same time, medical care places an ever-increasing drain on many retirees' finances. Hospital costs have risen at nearly twice the rate of overall inflation in the past 12 months, and over the longer run, health care has seen huge price increases that are straining government programs like Medicare and Medicaid to the breaking point. Yet, medical costs make up only 7% of the CPI -- a far cry from the estimated $230,000-$250,000 that retirees can expect to pay for health-care expenses over the course of their retirement years.

And Then There's the New Threat

Even worse, some are looking to reduce cost-of-living increases in Social Security benefits that are linked to inflation. When the so-called "supercommittee" met last year to discuss ways to cut the federal budget, one proposal suggested using what's known as the "chain-weighted" CPI to calculate cost-of-living increases. According to estimates, using the chain-weighted CPI would save $200 billion over 10 years -- $200 billion that would come from lower annual raises for retirees' Social Security benefit checks.

For now, that proposal doesn't look like it'll become reality anytime soon. But the move was just the latest in a series of arguments about whether the CPI overstates or understates inflation. As the federal budget becomes an increasingly important issue, you can expect to see more attempts to use the CPI as a way to rein in spending in an opaque but very detrimental way for retirees.

What to Do

As you plan for your own retirement, keep in mind that just because government numbers may reflect relatively low inflation in recent years, you can't necessarily count on prices staying low in your own personal budget.

If you do everything you can to build some leeway into your personal expenses, you'll be better able to handle whatever price shocks may come around in the future. With new calls for $5 gasoline, hanging onto every penny you can is only going to get more important in the coming months and years.

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