Knowing something about the Social Security retirement benefits calculation process can help beneficiaries better understand the claiming strategy philosophy later. It’s important to understand how Social Security calculates retirement benefits for retired American workers.
Social Security Administration (SSA) has used the same criteria and methodology to calculate Social Security retirement benefits since the late 1970s. It first determines the worker’s eligibility for benefits, calculates average indexed monthly earnings (AIME), calculates primary insurance amount (PIA), and translates PIA into the worker’s retirement benefit (based on the age at which he or she claims retirement benefits from Social Security). Let’s explore the steps SSA uses to calculate each worker’s Social Security retirement benefits in greater detail.
Step 1: SSA Determines the Worker’s Eligibility for Social Security Retirement Benefits Calculation
In order to claim benefits from Social Security, the worker must have a minimum amount of taxable income over at least 10 years or 40 quarters. The worker’s Social Security Statement recaps his or her taxable income over a lifetime. Although Social Security used to mail out a hard copy of the Social Security Statement, it’s now possible to review the statement online with a My Social Security Account:
It’s important for everyone who pays into the Social Security system to check the Social Security Statement at least once each year. If SSA doesn’t have the correct earnings record, it’s important to correct error(s) as soon as possible.
Contact Social Security at 1-800-772-1213 and submit Form 7008 according to instructions.
Also, it’s important to know that earnings are capped up to the maximum for the year. In 2016, the maximum taxable income level is USD 118,500 in 2016.
SSA then calculates the average indexed monthly earnings, or AIME.
Step 2: SSA Calculates the Worker’s AIME
AIME is an average amount of the highest 420 months, or 35 years, of the beneficiary’s income up to the maximum table annual amounts. Earnings up the age 60 are then indexed to account for average wage expansion and inflation using the National Average Wage Index. For individuals with less than 35 years of earnings, SSA includes additional months with USD 0 income earnings.
If the beneficiary has worked 35 years and continues to work, he or she continues to pay into Social Security with payroll taxes. However, in order to impact the worker’s benefits, he or she must earn increasing higher wages after the 35 year period.
SSA then calculates the worker’s primary insurance amount, or PIA.
FRA then gradually increases towards age 67 for beneficiaries born in 1960 or later.
SSA’s translates the worker’s AIME via a progressive formula. SSA’s benefit formula favors workers who earned less over a lifetime by attributing a higher percentage of AIME. That is, PIA provides up to 90 percent of income replacement for workers in the lowest level of AIME, 32 percent income replacement for middle earners, and just 15 percent for workers in the highest range.
According to SSA, the average replacement rate is about 40 percent of average wages earned by Americans in any year.
Most people don’t think of Social Security retirement benefits as a form of income replacement. Those with lower than average (or higher than average incomes for a smaller span of years) incomes are provided higher income replacement rates. Individuals enjoying above-average incomes over a longer period receive lower income replacement rates by SSA’s progressive formula.
Step 4: Translate the Worker’s PIA into a Retirement Benefit Amount According to Claiming Age
The PIA calculation is used to provide the beneficiary’s Social Security retirement benefits at Social Security Full Retirement Age. If the beneficiary claims before reaching FRA, benefits are adjusted downward. If the beneficiary delays claiming Social Security retirement benefits past FRA, benefits are adjusted upward:
For every month the beneficiary delays claiming benefits past FRA, his or her Social Security retirement benefit increases 0.67 percent. This translates to an eight percent increase (not compounded) a year.
For each month the beneficiary claims early benefits in relation to FRA, the Social Security retirement benefit declines by 0.56 a month for 36 months and 0.42 percent for months after that.
SSA’s adjustment design strives for actuarial fairness. In theory, claiming early retirement benefits allows the beneficiary to claim benefits over a larger number of years. In comparison, delaying the claim of benefits allows the beneficiary to receive a higher benefit over fewer years. Again, in theory, it shouldn’t matter that much when the beneficiary claims Social Security retirement benefits.
SSA Pays Beneficiaries to Delay Claiming Social Security Retirement Benefits
Unfortunately, SSA’s actual design was put into place decades ago. These conclusions are no longer true for today’s retirees. Delaying Social Security benefits past FRA puts eight percent per year in the retiree’s pocket. In today’s low yield environment, most retirees are hard-pressed to find a guaranteed eight percent return on money for four years (the difference between FRA at age 66 and 70). Beneficiaries must claim retirement benefits by age 70.
Let’s look at how the beneficiary’s claiming age is used to adjust PIA—and calculate the actual Social Security retirement benefit:
If the beneficiary claims at age 62 with an FRA of age 66, he or she receives 75 percent of full Social Security retirement benefits. If his or her FRA is age 67, the percentage of retirement benefits declines to just70 percent.
At age 63 and an FRA of age 66, he or she receives 80 percent of Social Security entitlement. With an FRA of 67, the percentage declines to 75 percent of full benefits.
At age 64 and an FRA of age 66, the beneficiary locks in 87 percent of his or her maximum Social Security retirement benefit. If he or she has an FRA or 67, the percentage of benefits declines to 80 percent.
At age 65 and an FRA or 66, the beneficiary receives 93 percent of maximum retirement benefits. At an FRA of 67, the amount declines to 87 percent.
At age 66 with an FRA of 66, the beneficiary receives 100 percent of the retirement benefit. If he or she has an FRA of 67, the amount declines to 93 percent of the maximum calculation.
The age at which the beneficiary claims retirement benefits matters:
If the beneficiary’s FRA is age 66 but he or she waits just a year to claim them (to age 67), the Social Security retirement benefit increases to 108 percent of FRA maximum. If the worker’s FRA is age 67, he or she locks in the FRA retirement benefit at that time.
If the worker’s FRA is age 66 and claims benefits age 68, he or she receives 116 percent of the FRA maximum benefit. If the FRA is age 67, he or she adds eight percent a year to the maximum retirement benefit or 108 percent of benefit.
If the beneficiary delays claiming benefits to age 69 and has an FRA of age 66, he or she receives 124 percent of the FRA benefit. The younger worker who’s FRA is age 67 receives 116 percent of the FRA benefit by waiting just two years to claim Social Security retirement.
If the beneficiary waits to age 70 to claim Social Security retirement with an FRA of age 66, he or she receives 132 percent of the FRA benefit. The younger worker with an FRA of age 67 locks in 124 percent of his or her FRA benefit.
Even if the Social Security retirement benefits calculation seems complex for most, the conclusion for beneficiaries is simple. SSA pays future Social Security retirement beneficiaries to wait, up to age 70.