A Social Security 'Mystery' - Solved!

Now that Social Security has resumed sending estimated benefit statements(1), one of the most frequent questions I hear is, “How do they calculate how much I’m going to get?”  Frankly, Social Security is pretty transparent.  The website explains this in several places. (Although the math can get a bit overwhelming.) 

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If you are between statements and perhaps wondering how your new raise will affect the size of your Social Security check, there are several calculators that will allow you to project your benefit; however, your future earnings will affect the ultimate outcome and your exact benefit will not be set in stone until you actually file.(2)   

Getting “Credit”

In order to be eligible for a Social Security retirement benefit you must have at least 40 “credits.”  (These used to be referred to as “quarters,” but that is outdated.) 

No matter how much money you make you can only earn a maximum of 4 credits per year.  This year you receive one “credit” for every $1,220 you earn by working in a job that deducts Social Security tax (FICA) from your paychecks.  In essence, if you earn $4,880 in a single day at work, you have maxed out your full allotment of credits for 2015.

Notice that someone who earns the maximum number of credits per year only needs to work for 10 years to be eligible for a Social Security benefit: 

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4 credits/year x 10 years = 40 credits

A Lifetime of Earnings

Keep in mind that although ten years of work can technically qualify you for a retirement benefit, this will not result in a substantial check.  This is due to the fact that Social Security looks at your 35 highest years of inflation-adjusted income when calculating your benefit amountIf you didn’t work that long, a “zero” will replace each missing year of earned income.

This is a major reason so many Baby Boom women are shocked at how small their benefit is.  Though women from this generation went to work in higher numbers than any had previously, many withdrew from the “paid” workforce in order to provide family caregiving for an average of 11 years.  In most cases, this time involved raising children or helping dependent parents.  As a result, even if a woman had a relatively high-paying job for 24 years, when calculating her benefit, Social Security must enter $0 for eleven out of 35 years of her work history.  Each year that this woman returns to the (paid) workplace means one of those $0 years drops off.  This can have a significant impact on the size of her benefit.

Adjusting for Inflation

My first full-time job as a 22-year old college graduate paid $14,000/year.(3)  That seemed like a fortune at the time.  However, because of decades of inflation, today this amount of income would be considered barely above the poverty guideline for a single individual ($11,770).  

Thus, when calculating my retirement benefit at full retirement age (66), Social Security adjusts previous earnings to reflect the wage inflation that has occurred over the years.  My $14,000/year salary would equate to roughly $66,000/year today.  According to Social Security, this “ensures that a worker’s future benefits reflect the general rise in the standard of living that occurred during his or her working lifetime.”

Up until I reach age 60, Social Security applies the “national average wage index” to transform my annual wages into an equivocal amount in today’s dollars.(4)  When I apply for Social Security, it will pick the highest 35 of all my years of earnings.

Finding Your AIME

Once it identified your highest 35 years of wage-adjusted income Social Security divides this total by 420- the number of months involved.  This provides your “Average Indexed Monthly Earnings,” or AIME. 

For instance, take the case of someone we’ll call “Margie.”   She earned at least the Social Security wage base- the maximum amount of income you have to pay FICA tax on- for each of the past 35 years.  She retires in 2015 at age 66.  The total of her 35 highest years of indexed earnings would be $3,492,021.  Divide this by the number of 420 and you come up with an AIME of $8,314.

PIA, Please

The final step is to use the AIME to calculate something called your “Primary Insurance Amount,” or PIA.   This is the main ingredient of your retirement benefit as well as a number of other types of benefit you might be eligible to receive from Social Security.

To calculate this, your AIME is divided into three amounts based upon what are called “bend points.”  These are simply income levels.  Bend points are adjusted for inflation annually.  No matter what age you retire, you use the bends points that apply for the year that you turn 62. 

In Margie’s case, she became “eligible” for Social Security in 2011- the year she celebrated her 62nd birthday.  The bend points that apply for 2011 are: $749 and $4,517.

It’s important to understand that Social Security benefits are designed to replace a larger portion of earnings for lower income workers.  To this end, your AIME is divided into three sections based upon your bend points.  The largest replacement percentage- 90%- is applied to your AIME below the first bend point.  32% of the amount between the first and second bend points is added to this.  Only 15% of the amount above the second bend point is counted.

Here’s how Social Security’s math works out for Margie, a relatively high-income earner:

  • AIME: $8,314
  • 1st Bend Point:  $749               2nd Bend Point: $4,517
  • Bottom Earnings Tier: $749 x 90%= $674.10
  • Middle Earnings Tier: ($4,517-749) x 32%= $1,205.76
  • Top Earnings Tier: ($8,314-$4,517) x 15%= $569.55
  • Total: $2,449.41

Since Margie is not retiring at age 62 but, instead, has waited until her Full Retirement Age of 66, the final adjustment is to apply annual cost-of-living adjustments (COLAs) from 2011 through 4014 to this amount.  These ran (respectively) 3.6%, 1.7%, 1.5% and 1.7%.

This gives Margie a Primary Insurance Amount of $2,663.80.  The final step is to round this down to the next lowest dollar.  Margie’s Social Security benefit will be $2,663.00.

The PIA Pivot Point

As mentioned, your PIA is the starting point for numerous types of Social Security benefits.  If your Full Retirement Age (FRA) is 66 and you file to begin benefits at age 62, your PIA will be permanently reduced by 25%.   On the other hand, for each year past FRA that you delay claiming Social Security it will increase by 8% thanks to something called the Delayed Retirement Credit (DRC).  If your FRA is 66 and you postpone the start of benefits until you are 70, your check will increase by a minimum of 32%.

Your PIA also affects benefits that your spouse (current, ex-, or widowed)  and dependents might be entitled to.

1. If you are age 60 or older you will receive your estimated benefit statement three months before your birthday.  Younger workers will get this on the “fives”- 25, 30, 35, 40, etc.  If you’ve only been working (and contributing to Social Security) for a few years the most important reason to check this over is to make sure that the income amounts are correct; these are what your future benefit will be based upon.

2. For a list of Social Security’s calculators, visit http://search.socialsecurity.gov/search?affiliate=ssa&query=benefit+calculator

3.  Coincidentally, $14,100 was the maximum income someone paid Social Security tax on that year. 

4. Once you reach age 60, your earnings are taken at face value.

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