Determining Social Security Benefits
Social Security benefits are based on earnings averaged over most of a worker’s lifetime. Most people know about Social Security retirement benefits, but the program also pays benefits to disabled workers. In addition, families can receive benefits under certain circumstances. The formula that the agency uses to determine the benefits for a worker or the worker’s family is complex. Complicating matters even more are a number of special circumstances that can alter those benefits.
What follows is a general analysis that is suitable for policymakers. For individual cases, it would be wiser to seek guidance from the Social Security Administration or other sources.
When Can a Worker Retire? There are two answers to this question. A worker can collect partial Social Security retirement benefits as early as age 62 but cannot receive full retirement benefits until ages 65 to 67, depending on date of birth. Workers born before 1938 can receive full retirement benefits starting at age 65. The full retirement age increases by two months per year for workers born between 1938 and 1942 and is 66 for those born between 1943 and 1954. The full benefits age then increases by two months per year for those born between 1955 and 1959 and is 67 for anyone born in 1960 or later.
If a worker decides to collect benefits starting at age 62, the monthly payments will be reduced by a set percentage for each month that the worker receives benefits before full retirement age. As the full retirement age increases from 65 to 67, workers who retire early will receive an even greater reduction in their monthly benefits. A worker with a full retirement age of 65 who retires at 62 will receive 80 percent of the full retirement amount. A worker with a full retirement age of 66 retiring at 62 would see his Social Security benefits reduced by about 25 percent. This will eventually drop to 70 percent for those with a full retirement age of 67.
Workers may also increase their benefits by working beyond the full retirement age. Benefits increase by about 8 percent for every year until age 70, in which the worker does not receive Social Security. Once a worker turns 70, Social Security benefits do not increase further.
Qualifying for Retirement Benefits. To qualify for Social Security benefits, a worker must earn at least 40 quarterly credits—10 years’ worth of payroll tax payments. A worker earns one credit by earning at least $1,200 in a three-month period and paying Social Security taxes on that amount. Workers who earn $4,800 during a year earn four credits.
The amount of income required to earn a credit is adjusted annually, but this does not affect credits that have already been earned. Once a worker has earned the required 40 credits, he or she is permanently qualified. However, the level of benefits depends on income history.
The Disability Insurance program has similar requirements, but the number of credits necessary to qualify varies depending on the age at which the worker becomes disabled. In general, the younger the person, the lower the number of credits required to qualify for benefits.
The General Formula for Retirement Benefits. Retirement benefits are based on a worker’s highest 35 years of earnings. Those wages are indexed so that they have the purchasing power of the year when the person retires. The worker’s Average Indexed Monthly Earnings (AIME), or average monthly salary, is calculated using the 35 years of indexed earnings. The AIME is then run through a formula that calculates benefits equal to 90 percent of AIME up to a certain level of monthly income ($816 in 2014); 32 percent of AIME from that level to a higher point (between $816 and $4,917 in 2014); and 15 percent of the remaining AIME.
The dividing points between the three payment levels are known as “bend points.” The three payment levels are added up to find the worker’s monthly Social Security retirement benefit. Both steps are detailed below.
Determining Average Indexed Monthly Earnings (AIME). Retirement benefits are calculated using a worker’s highest 35 years of earnings. They do not have to be consecutive years. If the worker has an earnings record for more than 35 years, only the 35 years of highest earnings are included in the calculation; years with lower earnings are dropped. Only those earnings on which the worker paid Social Security taxes are counted. Thus, if the worker earned $120,000 in 2014, that year’s income would be counted as $117,000 for determining benefits, since the worker paid Social Security taxes only on the lower amount.
Earnings for previous years are indexed so that all years are measured by the same ability to purchase goods and services. Social Security uses the average wage index for two years prior to retirement. Thus, a person retiring in 2013 would see his wages through 2011 indexed to the 2011 average wage index; the two years immediately before retirement, in this case 2012 and 2013, are not indexed. This indexing increases past earnings to account for inflation as well as increases in average wage growth. For instance, it would take $5.67 in 2013 dollars to equal $1.00 earned in 1973 and $2.04 to equal $1.00 earned in 1990.
Once the 35 years of highest earnings are determined, they are totaled and divided by 420 (the number of months in 35 years). The result is the AIME, which is used to calculate Social Security benefits.
Some jobs—usually for state or local governments or certain religious organizations—are not covered by Social Security, and earnings for those jobs are not included in calculated AIME. For the purposes of determining Social Security benefits, those years count the same as if the worker was not employed.
If a worker did not work for a full 35 years—perhaps due to raising a family or because of illness—the missing years are counted as zeros. For example, if a worker is either employed for only 25 years or worked in a job covered by Social Security for only 25 years, the indexed earnings from those 25 years are added together and divided by 420—lowering that worker’s AIME to account for the missing years. Social Security benefits earned by state and local government workers are adjusted in other ways, as explained below under “The Government Pension Offset” and “The Windfall Elimination Provision.”
Wage Indexing vs. Price Indexing. In creating AIME, a worker’s past wages are indexed to bring them to the same level as today’s earnings. There are two general ways to index past earnings and potentially dozens of variations on these two that would create results that lie between the two general methods. This calculation is done only once in a worker’s life—when he or she first applies for Social Security benefits. Once the worker’s initial monthly benefit has been determined, it is price indexed in each successive year to protect the retiree from inflation.
Price indexing is based on the Consumer Price Index (CPI) and compensates for inflation. Price indexing benefits ensures that they maintain their constant purchasing power. In this case, if inflation had increased by 5 percent since last year, simply multiplying the previous year’s benefit by 1.05 to reflect inflation would preserve the retiree’s ability to buy the same amount of goods as last year. His monthly benefit, for instance, would go from $1,000 to $1,050. However, there are several potential ways to measure prices, each of which produces a slightly different result. Social Security has used the same index since cost-of-living adjustments first started in 1975, but there is controversy about whether it is the best index to use.
By contrast, wage indexing is based on the growth in average wages in the economy over a set period of time and is supposed to allow workers to retire with the same standard of living. The growth in average wages includes both inflation and growth in the overall economy. As a result, wage indexing almost always results in a higher AIME than price indexing. Social Security uses wage indexing only when calculating AIME, determining the annual level of bend points in the benefit level, and determining the annual level of the payroll tax earnings cap.
The difference between the two forms of indexing can be important. If someone worked as a bricklayer throughout his career and earned $4.00 per hour in 1980, indexing that amount for inflation (an increase of 163 percent) would result in an indexed wage of $10.55 per hour. On the other hand, indexing for average growth in wages (an increase of 243 percent) would result in $13.73 per hour. While it is true that $10.55 in 2013 would buy the same amount as $4.00 in 1980, the average wage for a bricklayer could have increased to something closer to $13.73 per hour in 2013.
Wage indexing allows retirees to take advantage of the increase in the standard of living over their working careers. However, it is often criticized as giving workers a retroactive credit for improvements in the economy. In other words, the worker’s 1980 wages are being measured according to the standards of the 2013 economy rather than according to the standards of the 1980 economy in which they were earned.
The key difference lies in replacement rates. The replacement rate is the proportion of a worker’s average monthly earnings that is paid by that worker’s Social Security retirement benefit. Currently, Social Security pays average-income workers a retirement benefit equal to between 39.8 percent and 42.9 percent of their average monthly earnings. Lower-income workers generally receive a higher proportion of their average monthly earnings, while higher-income workers receive a lower proportion. However, the amount that an individual actually receives may be altered because Medicare premiums are deducted from Social Security benefits before they are sent to the recipient.
With wage indexing, these basic replacement rates will remain roughly stable. On the other hand, changing to price indexing will gradually reduce the replacement rates. While this would bring promised Social Security benefits closer to what the program can afford to pay, it would also require workers to make up the difference from savings or some other form of retirement plan. Most experts believe that a retiree needs an income equal to roughly 70 percent to 80 percent of pre-retirement income for a comfortable retirement.
Annual Cost-of-Living Adjustment (COLA) Increases. Once a worker’s monthly benefits have been determined, they are increased every year by the rate of inflation. This cost-of-living adjustment (COLA) is intended to preserve the purchasing power of a recipient’s benefits. The amount of the annual increase is announced each October and takes effect the following January.
COLA is based on the inflation rate for the preceding 12 months from October 1 to September 30. For example, in October 2013, the Social Security Administration announced a COLA increase of 1.5 percent for all checks issued after January 1, 2014. This increase was based on the change in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) from October 1, 2012, through September 30, 2013. If there is no increase in inflation during that calculation period, there are no new COLAs until the inflation index is higher than it was at the end of the previous measuring period.
The Social Security Administration currently uses the Department of Labor’s CPI-W to measure inflation, but the law allows it to substitute other inflation indexes or the annual increase in average wages under some circumstances.
A more accurate index is now available than was available when Social Security first implemented its COLA. In 1975, the Bureau of Labor Statistics published only the CPI-W. It is based on prices paid by urban wage workers and clerical workers, who make up only 32 percent of the population. The broader Consumer Price Index for All Urban Consumers (CPI-U), from which the chained CPI is derived, covers 87 percent of the population. The CPI-W is not only outdated and covers only a small subset of the population, but also fails to account for how consumers respond to changing prices.
The chained CPI more accurately measures the cost of living by correcting existing flaws that allow inflation-adjusted benefits to rise in both absolute and relative purchasing power over time. Excess COLA increases from the current flawed index are contributing to Social Security’s long-term fiscal insolvency. Lawmakers could eliminate about one-fifth of Social Security’s long-term fiscal imbalance by implementing a chained-CPI COLA. However, if lawmakers allow Social Security benefits to continue to increase faster than the cost of living, the excess payments will result in earlier and deeper cuts for Social Security recipients, beginning in less than 20 years.
Using Bend Points to Calculate the Monthly Benefit. Once an AIME has been determined, the Social Security Administration calculates a worker’s monthly retirement benefit using a formula that pays a higher benefit relative to income to lower-income workers than to higher-income workers. In 2014, Social Security will pay 90 percent of the first $816 of a worker’s AIME, 32 percent of the AIME amount between $816 and $4,917, and 15 percent of any AIME amount over $4,917. The Social Security Administration adjusts these bend points each year.
The bend points ensure that a lower-income worker receives Social Security retirement benefits that are comparatively higher than the pre-retirement income that an upper-income worker receives. For example, a worker with an AIME of $5,000 (that is, average annual income of $60,000) would receive 90 percent of the first $816 ($734.40); 32 percent of the amount between $816 and $4,917 ($1,312.32); and 15 percent of the amount between $4,917 and $5,000 ($12.45). Thus, the worker’s monthly benefit would be $2,059.17, or about 41.1 percent of AIME.
On the other hand, a worker with an AIME of only $1,600 (or an average annual income of $19,200) would receive 90 percent of the first $816 ($734.4) and 32 percent of the amount between $816 and $1,600 ($250.88), for a total monthly benefit of $985.28. This lower monthly benefit amount would equal 61.6 percent of the AIME.