Understanding how your Social Security monthly benefit is calculated is a very important piece of the retirement planning process. You don’t have to be a professional actuary to gain a helpful perspective of how those dollars you paid into Social Security throughout your career translate into the monthly benefit amount you see on your Social Security statement.
1. Check Your Earnings Statement
Before you get out a calculator, you might need to find an old tax return first. Included in your latest Social Security statement should be a record of your earnings over your career. Most people are able to give the earnings record a brief look over to verify it’s correctness, while others might notice an abnormality or strange zero in a year they are sure they worked. If the error is in the current or last year, it might be reconciled in a later statement. It’s important that every retiree doesn’t assume Social Security has kept accurate records on your behalf. If you notice an error on your earnings statement, here’s a helpful publication from Social Security of what to do.
2. Calculating Your Average Indexed Monthly Earnings (AIME)
Unlike many defined benefit plans that factor in your highest 3-5 years of consecutive earnings, the AIME component of Social Security looks at your 35 highest individual years of earnings (capped at the max amount subject to Social Security tax), regardless of when they occur. Any of the highest 35 years used in this formula that happen before you turn 60 years old are indexed for inflation into today’s dollar amount. Finally, you add these inflation adjusted 35 years worth of earnings and divide by 420 (how many months there are in 35 years) – this is your AIME.
Most people would do well to understand the general concept of AIME, without diving into the deep weeds of the calculations above. Instead, spending the time verifying your earnings statement is correct is more than likely a better use of your time. Social Security calculates your AIME for you.
3. Calculating Your Primary Insurance Amount (PIA)
Your PIA is a number that represents the culmination of a lifetime of paying into the Social Security system. It’s the monthly benefit amount you will receive at your full retirement age (find your full retirement age here). Imagined another way, it’s what an actuary who works for the Social Security Administration has decided is a fair monthly benefit compensation for all of the years you’ve paid in. If you decide to file before your PIA, you will receive a smaller monthly benefit. If you decide to file after your PIA, you will receive an 8% larger benefit every year you defer. Understanding how Social Security arrives at this number is helpful.
Let’s focus on the red Bend Point Formula box in the illustration above. As early as 1939, amendments to the original Social Security Act stipulated that monthly benefits replace a higher proportion of pre-retirement earnings for people with lower earnings compared with those with higher earnings (Martin and Weaver 2005). Said another way, Social Security is a progressive system in which those who earn less (and pay in less) will receive a higher percentage of their pre-retirement income. This is evident in the formula used to calculate your PIA:
Bend Point Formula:
90% of AIME up to $856, plus
32% of AIME between $856 and $5,157, plus
15% of AIME above $5,157.
Higher Income Worker Example:
Bend Point Calculation (Replacement Income Rate = 31.7%)
PIA = [.90 * $856] + [.32 * ($5,157 – $856)] + [.15 * ($8,200 – $5,157)]
PIA = $2,603
@ 62 = .75 * $2,603
@ 62 = $1,952
@70 = 1.32 * $2,603
@70 = $3,436
Lower Income Worker Example:
Bend Point Calculation (Replacement Income Rate = 45.1%)
PIA = [.90 * $856] + [.32 * ($3,800 – $856)]
PIA = $1,712
@ 62 = .75 * $1,712
@ 62 = $1,284
@70 = 1.32 * $1,712
@70 = $2,260
From the benefit calculation analysis above, there are a few points that are worth explicitly mentioning.
- There is a maximum Social Security PIA attainable. In 2016, it is $2,639/mo.
- Social Security is designed to replace a higher % of pre-retirement income for lower income workers.
- Social Security is designed to replace a lower % of pre-retirement income for higher income workers.
- The Bend Point formula functions as a mechanism to redistribute wealth, just like our tax code.