Roughly one million Americans are receiving less Social Security than they were expecting, and the group includes teachers, firefighters, police officers, college professors, state troopers, park rangers, highway maintenance crews and federal workers hired before 1984. All of these individuals have one thing in common: in addition to Social Security, they’re also eligible for a government pension either at the federal,  state or local level.

This isn’t something new. Back in the 1970s is was clear that Social Security was headed for serious financial trouble. It was projected that by 1983 the agency would be insolvent. That is, the money collected via the payroll tax would not be enough to cover the benefits Social Security was obligated to pay retirees and other beneficiaries.

The program needed a major overhaul in order to survive because many of the assumptions on which the system was based had changed—life expectancy being a biggie. Thanks to medical and environmental advances, life expectancies had improved dramatically with  no end in sight. This meant Social Security benefits were being paid for many more years than projected.

During his first year in office, President Ronald Reagan appointed a blue ribbon commission (headed by a then-relatively obscure economist named Alan Greenspan) to address the problem and come up with recommendations to put Social Security’s long-term finances on a more secure footing.

Among other things, the panel made the following recommendations:

  • gradually raising the “full retirement age” from 65 to 66 and eventually to 67;
  • taxing a portion of the Social Security benefits received by higher-income individuals;
  • increasing the payroll tax rate;
  • requiring newly-hired federal employees as well as workers at non-profit organizations to join Social Security (and, of course, pay into the system);
  • create the “Windfall Elimination Provision.”

Congress adopted the recommendations and Regan signed the Social Security Amendments of 1983 into law.

The Windfall Elimination Provision, or WEP, adjusts the formula used to calculate an individual’s Social Security benefit if they are also entitled to a government pension, i.e. a job in which they did not pay payroll tax. To understand the reason behind this, it helps to know a little bit of Social Security’s history as well as the formula used to calculate benefits.

When you read the actual documents and correspondence leading up to the Social Security Act of 1935, it’s clear that the system was never meant to provide all or even most of a retiree’s income. Its primary intent was to prevent older Americans from living in abject poverty by providing a basic level of income.

This philosophy underlies the formula used to determine the amount of your benefit. First, your 35 highest years of (Social Security-covered) earnings are adjusted for inflation. From this, Social Security calculates the average indexed monthly earnings (AIME) you were paid over your work life. This is broken into three different brackets (the upper dollar amount of each is called a “bend point”). The amount of income that falls into each bracket is multiplied by a certain percent and this determines how much of that income bracket will be replaced by Social Security.

If you’re applying for Social Security retirement or disability benefits this year, the brackets and replacement percentage are:

 

AIME Bracket Percent Replaced
First $791 90%
>$791 through $4,768 32%
Above $4,768 15%

The result of this formula is that those with lower average lifetime income see a larger portion of their pre-retirement income replaced by Social Security. For instance, assume Mary’s Average Indexed Monthly Income (AIME) is $700 and Tracey’s is $5,000.

    MARY TRACEY
AIME Bracket Percent Replaced Amount Amount
First $791 90% $700X90%=$630.00 $791X90%=$711.90
>$791 through $4,768 32% $0 $3,977X32%=$1,272.60
Above $4,768 15% $0 $232X1515%=$34.80
Social Security Benefit   $630.00 $2,019.30
Income Replacement   $630/$700=90% $2,019.30/$5,000=40%

Clearly, Tracey’s Social Security benefit is significantly higher than Mary’s, but that’s just part of the story. After all, because of her higher lifetime earnings, Tracey also paid a lot more in Social Security tax than Mary. However, in terms of replacing her pre-retirement income, Mary is in a significantly better position than Tracey, who is only seeing 40% of her pre-retirement income replaced by Social Security.

This might seem unfair, but it’s the way Social Security is designed: the benefit paid replaces a larger portion of the pre-retirement income earned by low-income workers. Although these individuals receive a smaller benefit in terms of dollars, it is higher in terms of the percentage of pre-retirement income being replaced. As a result, it provides a floor to support a basic standard of living.

Now consider another example: Bob started working for the city police department shortly after college and retired in his early 50s with a full pension. Then he got a new job working in private security and for 10 years, Social Security tax was deducted from his paycheck. 

Social Security has no information about Bob’s work in the public sector or the fact that he will receive a pension of $3,270/month from the city. From Social Security’s perspective, Bob’s lifetime earnings only include his 10 years of Social Security-covered wages. Based on the formula above, Social Security estimates he will receive a benefit of $793/month.

However, when Bob applies for Social Security, that’s when his police department pension is revealed and it turns out that Bob is no longer a “low-income” earner! In fact, he will receive quite a comfortable income compared to the average retiree. To account for this, the Windfall Elimination Provision requires that the formula used to calculate Bob’s Social Security benefit be adjusted to reduce the amount of income Social Security will replace. Bob is shocked to learn that his monthly Social Security check will only be $395- half the amount he expected. 

If you earned a government pension (or in some cases, a foreign pension) and also worked in Social Security-covered employment, you can quickly find out whether- and by how much- you Social Security benefit will be affected. Visit the calculator here.

If you receive a government pension, this can also reduce a spousal, widow’s or widower’s benefit that you’re entitled to. In this case, a different formula- the Government Pension Offset- is applied. For more information, click here

Reminder: Starting March 1, Social Security will no longer send benefit checks by mail. If you don’t sign up to have your benefits electronically deposited into your checking account, you will receive them via the Direct Express card program. You don’t need a checking account for the Direct Express program. Essentially, this is a debit card which is loaded with your benefit amount each month. For more information, go here.

Ms. Buckner is a Retirement and Financial Planning Specialist and an instructor in Franklin Templeton Investments' global Academy. The views expressed in this article are only those of Ms. Buckner or the individual commentator identified therein, and are not necessarily the views of Franklin Templeton Investments, which has not reviewed, and is not responsible for, the content. 

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