Where Did Your Money Go? Why You Get So Little Back.
Economizer Special Edition #21425 (Part three of three on Social Security)
How does the Social Security benefits formula determine my benefits?
These are the six steps involved in using the Social Security benefits formula to determine the benefits you'll receive.
1. Determine wages for each year you worked (get them on your online SS account)
Your earnings record will list your wages for every year you worked and paid into the Social Security system. The amounts shown will be yours, not employers.
2. Adjust your wages for inflation
Social Security adjusts wages for inflation. The average wage index (AWI) is a measure of U.S. wages.
The AWI that applies to adjust your wages for inflation is the AWI in effect two years before you become eligible for Social Security. You become eligible for Social Security at 62, so you're subject to the AWI in effect
in the year you turn 60.
(You can find a complete list of AWIs dating back to 1951 on the SSA website)
If you turned 62 in 2019, you'd use the 2017 AWI -- $50,321.89 -- to determine how to adjust each year's wages for inflation. The formula to adjust your wages requires you to get a calculator:
Divide the AWI in effect the year you turn 62 by the AWI in effect in the year you're adjusting the wages for. This will give you the indexing factor.
Multiply the relevant year's wage by the indexing factor to determine your inflation-adjusted wage.
Example of how this formula works for you:
To adjust your wages from 2012, divide $50,321.89 (AWI in the year you turned 62) by $44,321.67 (AWI from 2012). This gives you an indexing factor of 1.135. Multiply your 2012 earnings by the indexing factor for that year. If you earned $40,000 in 2012, your index-adjusted wage would be $45,400 ($40,000 times the 1.135 indexing factor).
To adjust your wages from 2013, figure out the indexing factor by dividing $50,321.89 by $44,888.16 (the AWI in 2013). The indexing factor is 1.121. Multiply 2013 earnings by 1.121. If you earned $41,000, your index-adjusted wage would be $45,961 ($41,000 * 1.121).
Do this math for each year you have earnings to figure out that year's index-adjusted wage.
Shortcut
The SSA also lists the current eligibility year. You can look up the indexing factors that apply and multiply each year's indexing factor by the relevant year's wages. This will give you your index-adjusted wage for every year you worked.
3. Calculate your AIME
Once you know how much your index-adjusted wage is for each year, add together the total amount of inflation-adjusted wages earned in the 35 years you earned the most. So, based on our above examples, you would add in $45,400 for 2012 + $45,961 for 2013, and so on for each of the 35 years with the highest index-adjusted income.
Next, divide by 35 to get your annual average, and divide this number by 12 to get your average indexed monthly earnings (AIME).
Say you added up all of your index-adjusted wages in the 35 years you earned the most, and you got $2,600,000. Divide $2,600,000 to see that your average annual adjusted wage is around $74,285.71. Divide by 12 to get an AIME of $6,190.48.
If you worked less than 35 years, you will have years of $0 wages factored in. If you only worked 30 years, you'd add in 5 years of $0 wages when determining your average. Obviously, years of $0 wages lower your AIME.
4. Apply the Social Security benefits formula to AIME
Once you know your AIME, put it into the Social Security benefits formula using the bend points in effect in the year that you turn 62. The table below shows 2014-2025 bend points for the first two.
If you turn 62 in 2019, the bend points to use in your Social Security benefits formula are $926 and $5,583. So, if your AIME was $6,190.48 as calculated in the example, here's how your benefits would be calculated:
90% of $926 = $833.40 (the above chart is 2019 yr., and the bend point is 926)
32% of $5,583-$926 = $1,490.24
15% of $6,190.48 (AIME from above)-$5,583 = $91.12 ( 3rd bend point)
Your primary insurance amount would be $833.40 + $1,490.24 + $91.12 = $2,414.76.
If you turned 62 in 2018, different bend points apply: $895 and $5,397. So, if your AIME was $6,190.48, your primary insurance amount in 2018 would be $2,365.16:
90% of the first $895 = $805.50
32% of $5,397-$895 = $1,440.64
15% of $6,190.48-$5,397 = $119.02
$805.50 + $1,440.64 + $119.02 = $2,365.16.
5. Apply cost-of-living adjustments
If you claim benefits after 62, you'll be entitled to an increase in your primary insurance amount based on each subsequent year.
COLAs are calculated based on increases in cost of living as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). You can see for the years 1975 to 2019 on the SSA website.
Say your primary insurance amount -- as calculated in 2019 when you turn 62 -- is $2,414.76. If there's a 2% cost-of-living adjustment from 2019 to 2020, you'd apply the COLA, so your primary insurance amount the next year would become $2,463.06 (2% more than $2,414.76). If there's a 1% COLA adjustment from 2020 to 2021, your primary insurance amount the next year would be $2,487.69 (1% more than $2,463.06).
6. Adjust your primary insurance amount if you claim benefits before or after full retirement age
All the above calculations determine the primary insurance amount if you claim benefits at Full Retirement Age -- but you may decide to claim benefits before or after FRA. You can claim benefits as early as age 62. But if you claim benefits before FRA, your benefits are decreased by:
5/9 of 1% per month for each month before FRA for the first 36 months.
5/12 of 1% per month for each additional month if you claim more than 36 months before FRA.
If you were born in 1960 and after your Full Retirement Age (FRA) is 67. See SSA’s website for more information if you were born before 1960.
Example: Depending on when your FRA is, you'd apply to your primary insurance amount. For example:
If your FRA is 67 and you claim benefits at 66, that's 12 months early. Multiply the per month-reduction ((5/9) *.01) times 12 months to see that benefits are reduced by around 6.7%.
If FRA is 66 and you claim benefits at 62, that's 48 months early. Multiply the per month-reduction for the first 36-months ((5/9) *.01) times 36 months + the additional reduction of ((5/12)*.01) times 12 months. This gives you 0.20 + 0.05, which amounts to a 25% reduction in your primary insurance amount.
If FRA is 67 and you claim benefits at 69, that's 24 months late. Multiply the per-month increase (2/3) *.01) times 24 months to see benefits are increased by 16%.
If you claim benefits after FRA, benefits are increased by 2/3 of 1% for each month you wait up until age 70.
Adjusting your primary insurance amount up or down based on the age when you claim benefits will let you know exactly what your benefits will be.
Now you know how the Social Security benefit formula works
Now you know exactly how the Social Security benefit formula works. To summarize:
Calculate Average Indexed Monthly Earnings (AIME). Do this by applying an indexing factor to each year of earnings to adjust for inflation, adding together your highest 35 years of adjusted earnings, dividing by 35 to find your annual indexed earnings, and dividing by 12 to determine your monthly indexed earnings. The indexing factor is determined by the Average Wage Index (AWI) in the year you turn 60.
Apply the Social Security benefits formula to your AIME to calculate your primary insurance amount. You'll receive 90% of AIME up to the first bend point, 32% of AIME between the first and second bend point, and 15% of AIME above the second bend point. Bend points are income levels determined by the Average Wage Index in effect the year you turn 62.
Adjust your primary insurance amount based on cost-of-living increases for each year after you turn 62 but before retirement. COLAs are determined each year using CPI-W, which is a measure of inflation that looks at increases in consumer prices for urban wage earners and clerical workers.
Receive your primary insurance amount if you claim benefits at full retirement age, which is between 65 and 67, depending on your year of birth.
If you claim benefits before full retirement age, you'll reduce your primary insurance amount by 5/9 of 1% per month for the first 36 months early and by 5/12 of 1% for each prior month early.
If you claim benefits after full retirement age, you'll increase your primary insurance amount by 2/3 of 1% per month up until the age of 70.
So, while the Social Security benefits formula may seem simple since you're just adding up different percentages of your average earnings over 35 years depending on how much you earn, there's a lot more to applying the formula than first meets the eye.
The Social Security benefits formula is progressive
Social Security, in general, is meant to replace about 40% of pre-retirement income. As you can see, the formula works to do that for most lower-income workers. Remember our example of a person with an AIME of $6,190.48. His primary insurance amount came to around $2,414, which is about 39% of his average inflation-adjusted wage.
However, the Social Security benefit formula is progressive. A progressive system redistributes income from people with higher lifetime average earnings to people with lower lifetime average earnings.
It's easy to see that the benefits formula is progressive because you get benefits equal to 90% of your AIME if you earned only a small amount of money -- but those who earned larger amounts get an ever-decreasing percentage of AIME factored into their benefits.
The result of this formula is that the ratio of lifetime benefits received by someone with lower earnings is higher, relative to payroll taxes paid, than the ratio of benefits to taxes paid for a higher earner.
Social Security was supposed to be part of a three-legged stool designed to support retirees, with pensions and savings providing additional income and serving as the other two legs of the stool.
However, with substantial savings shortfalls for many Americans and very few employers providing defined-benefit pension plans, many argue that Social Security benefits should be increased to provide a higher level of income to reduce senior poverty levels. This is an easy step by adjusting the Bend points to include more income, especially the 3rd bend point.
Defined benefit plans or Old School pensions are not the same as 401(k) type plans, which are just retirement savings accounts and offer no guarantees whatsoever.
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