Social Security is probably the most popular federal program, yet
most people know almost nothing about it. In practice, Social
Security’s complex benefit formulas and rules make it difficult for
people to understand how their retirement benefits will work.
This
paper explains what Social Security is and how it works. The first
section explains what Social Security is and which programs are and
are not part of Social Security. The second section explains the
payroll taxes that mainly finance Social Security and how they are
paid. The third section explains what Social Security’s trust funds
are and are not. The fourth and longest section discusses how Social
Security benefits are calculated and who is eligible to receive them.
A companion paper will discuss the fiscal problems facing the current
system and why changes are necessary. All of the information
contained in this paper comes from Social Security Administration (SSA)
sources.
What Is Social Security?
Social Security is the most popular government program and touches the
life of every worker in America, but most people know little or
nothing about how it operates. The following discussion explains what
Social Security is and how it operates.
Social Security’s
Major Programs.
While most discussions
focus only on Social Security’s retirement program, Social Security
actually consists of three major programs, all of which are
administered by the Social Security Administration. Specifically:
-
Retirement.
Social Security’s retirement
program provides a lifetime monthly income for qualified workers
once they reach their full retirement age. Depending on when they
were born, that age ranges from 65 to 67. The amount of retirement
benefits that a worker receives depends on his or her income while
working. Workers also have the option of receiving a lower monthly
income starting at age 62.
-
Survivors.
Social Security’s survivors program
provides a monthly lifetime income to the surviving spouse of a
deceased worker once he or she reaches retirement age. The amount of
the monthly benefit depends on both spouses’ income while they were
working. The survivors program also pays benefits to children under
the age of 18 and the surviving spouse caring for them. Unless they
are disabled, children’s benefits end when the last child either
reaches age 18 or graduates from high school, whichever is later.
-
Disability.
Social Security also pays lifetime
monthly income to workers who are disabled and, in some cases, to
their spouses and children under the age of 18. These benefits
depend on the worker’s earning history.
Qualifying for
Social Security.
Workers do not
automatically qualify for Social Security retirement benefits.
Instead, they must work and pay a minimum level of Social Security
taxes for at least 40 quarters during their working lives. These 40
quarters do not have to be consecutive. Currently, workers earn a
credit for each three-month period in which they earn at least $900.
Once they have worked and paid Social Security taxes for the required
40 quarters, they are fully qualified to receive Social Security
retirement benefits. If workers have paid Social Security taxes for a
certain number of quarters in the recent past,[1]
they are also qualified to receive disability benefits and to have
survivors benefits paid to their spouses and to their children who are
under the age of 18.
Disability benefits are paid to workers who have been disabled for at
least one year. In order to qualify, a worker must have paid Social
Security taxes within the recent past. “Disabled” in this case means
unable to perform any substantial gainful work due to severe physical
or mental impairment. Determination of eligibility is based on
medical evidence and made by a government agency in the state in which
the worker lives.
There is no requirement that an individual must be an American citizen
to qualify for Social Security. While employers are required by other
laws to ensure that anyone they hire is either a citizen or a legal
immigrant, foreign nationals can earn Social Security credits with a
valid Social Security number.
Supplemental
Security Income.
The Supplemental
Security Income (SSI) program is not part of Social Security. Even
though the Social Security Administration administers SSI, the program
is paid for with general tax revenues. No Social Security payroll
taxes are used to pay for SSI. SSI helps aged, blind, and disabled
people who have little or no income. It provides cash to meet basic
needs for food, clothing, and shelter. To get SSI, a worker must be
blind, disabled, or at least 65 years of age.
Medicare.
Medicare is a federal
program that helps to pay for older Americans’ health costs. Some
people incorrectly consider Medicare to be part of the Social Security
system because taxes that finance part of Medicare are lumped in with
those that pay for Social Security. However, Medicare is also
financed by premiums and general revenue, and it is not administered
by the Social Security Administration. For these reasons, Medicare is
not considered part of Social Security.
FICA.
The taxes that pay for
Social Security’s programs are confusing to most people. On most
workers’ paychecks, the taxes that pay for both Social Security and
Medicare are lumped together under the term “FICA” (Federal Insurance
Contributions Act). Even the amount under FICA is misleading because
it shows only half of the taxes paid on the worker’s behalf.
Payroll Taxes and Amounts
Unlike most other government programs, Social Security (like Medicare)
is funded through explicit taxes that are not supposed to be used for
any other purpose. These taxes are based on a worker’s earned income
and deducted from his or her paychecks. For that reason, Social
Security taxes are often referred to as “payroll taxes.” These payroll
taxes are in addition to any income taxes that the worker must pay.
Separate payroll taxes finance Social Security’s retirement and
survivors benefit program, Social Security’s disability benefit
program, and Medicare; yet the three are often lumped together as one
line item on a worker’s pay stub. The two Social Security taxes are
paid only on income up to a certain annual amount. Medicare taxes are
collected on all earned income.
In
2005, workers and employers will pay payroll taxes totaling 15.3
percent of the first $90,000 of income and 2.9 percent of income above
that amount. The $90,000 dividing line is called the “earnings
limit”—sometimes referred to as the “wage cap.” Of that 15.3 percent
total, 10.6 percent of income pays for Social Security’s retirement
and survivors program, and 1.8 percent pays for Social Security’s
disability program. The remaining 2.9 percent is used to pay for
Medicare programs, but the Medicare taxes are not subject to the
earnings limit. In other words, Medicare taxes are collected on all
of a worker’s earned income, not just the first $90,000.
The
worker and the employer each pay half of the payroll taxes. The
self-employed pay both portions.
FICA Defined.
The paycheck stubs from
most employers do not show the individual amounts that the worker pays
for Social Security and Medicare. Instead, these taxes are lumped
together and shown as a deduction for “FICA.”
The
Federal Insurance Contributions Act is the part of the Internal
Revenue Code that gives the federal government the authority to
collect the payroll taxes that pay for the Social Security programs
and part of Medicare. The name implies that the taxes for these
programs are actually contributions to a social insurance system. In
reality, however, they are nothing more than taxes, and it would be
more honest to refer to them as such.
Matching Deductions
by the Employer.
In most cases, only
half of the Social Security taxes that a worker pays are shown on the
paycheck stub. Employers also pay an equal amount of payroll taxes on
the worker’s behalf. As far as the employer is concerned, these
additional taxes are part of the worker’s pay. Even though the worker
never sees this income, the employer actually pays $10,765 for each
$10,000 the worker earns ($10,000 in wages and $765 in payroll taxes).
If that worker were not employed, the employer would not be required
to pay the $765 in taxes.
If
this money was not paid to the government as payroll taxes, it could
go to the worker as wages. For this reason, both halves of the FICA
tax should be counted as being paid by the worker. Thus, instead of
paying taxes equal to 5.3 percent of income for retirement and
survivors benefits, the worker is actually paying 10.6 percent of
income. The combined total is the true cost to each worker.
Self-Employed
Workers.
This reality is clearly illustrated by self-employed workers, who must
pay both the employer and the employee halves of the payroll taxes.
Combining the payroll taxes for Social Security’s retirement and
survivors program, Social Security’s disability program, and Medicare,
the self-employed pay a total of 15.3 percent of income below $90,000
in 2005 and 2.9 percent of income above that amount. These payroll
taxes are in addition to any income taxes.
Retirement and
Survivors Tax.
The largest portion of
FICA payroll taxes is used to pay for a worker’s retirement and
survivors benefits. The taxes pay for both the monthly benefits to
workers who have retired and the monthly benefits (after the worker’s
death) to their surviving spouses and children (under the age of 18).
The worker and employer each pay 5.3 percent for a total of 10.6
percent of income up to the earnings limit for these programs. These
taxes go into the Old-Age and Survivors Insurance (OASI) trust fund.
Disability Tax.
Taxes equal to 1.8
percent of income (up to the earnings limit) go into the Disability
Insurance (DI) trust fund and pay monthly benefits to workers who are
unable to work due to a long-term physical or mental disability. As
with all payroll taxes, half of the amount (0.9 percent of income) is
deducted from the worker’s pay, and the employer pays the other half
on the worker’s behalf.
The Earnings Limit.
In 2005, Social
Security taxes will be collected on only the first $90,000 that a
worker earns. This figure is known as the “earnings limit” and is
adjusted each year. Social Security benefits are paid only on the
amount of income that is subject to the Social Security payroll tax.
Thus, in Social Security’s eyes, both Michael Jordan and Bill Gates
earn $90,000 per year regardless of their actual incomes, and their
Social Security retirement benefits will reflect this.
The
earnings limit protects Social Security from having to pay benefits on
Bill Gates’s entire income. It allows the program to say that it
covers all Americans without paying the very rich benefits that are
much higher than those that go to average-income workers. Every
October, Social Security calculates and announces the earnings limit
for the following calendar year, based on the growth of wages in the
economy. Wage growth is slightly higher than the rate of inflation
(growth of prices).
Developed as part of the 1983 Social Security reforms, this formula
for increasing the amount of wages that are taxed for Social Security
was supposed to cover 90 percent of the nation’s total wages.
However, this proportion has gradually declined and is now closer to
85 percent.
Income Taxes on Some
Social Security Benefits.
Since 1983, retirees
with annual income above a certain amount have been required to pay
income taxes on a portion of their Social Security benefits. The money
raised through this tax is returned to either Social Security or
Medicare.
Retirees who earn between $25,000 and $34,000 and file as individuals
may have to pay income taxes on up to 50 percent of their benefits. If
they earn more than $34,000, they may have to pay income taxes on up
to 85 percent of their benefits. Married retirees who earn between
$32,000 and $44,000 may have to pay income taxes on up to 50 percent
of their benefits, and if they earn over $44,000, up to 85 percent of
their benefits may be taxable. These income thresholds are not indexed
for inflation. Income taxes on Social Security benefits are paid at
the same rates as on other types of earned income.
Until 1983, all Social Security benefits were income tax free. In that
year, Congress decided to tax 50 percent of the Social Security
benefits of workers with total retirement incomes over $25,000 (for
single retirees) because Social Security needed additional revenue.
Congress justified the move by pointing out that the half of payroll
taxes paid by employers can also be deducted from the employer’s
corporate income taxes, while workers must pay income taxes on the
amount of their check that is deducted as payroll taxes. Congress
decided that since companies received a tax deduction on the amount of
payroll taxes paid on behalf of their workers, Congress could
recapture that tax benefit by assessing income taxes on half of some
retirees’ benefits.
In
1993, problems with financing Medicare led Congress to raise the
proportion of Social Security benefits that is subject to income taxes
to 85 percent for workers with incomes over $34,000 (for single
retirees). The money raised from this tax goes to the Health Insurance
trust fund.
The Social Security Trust Funds
Many
people tend to think of their Social Security benefits as coming from
an actual account, in their name, which contains cash or investments.
People who believe this often point to the existence of the Social
Security trust funds to justify their belief. However, this belief is
fallacious for two reasons. First, Social Security has no individual
accounts at all, other than a bookkeeping record of an individual’s
yearly earnings and payroll taxes. Second, the program’s trust funds
do not contain cash or saleable assets. They only represent the amount
of Social Security taxes collected beyond what the program needs to
pay current benefits.
In
reality, the Social Security trust funds contain nothing more than
IOUs that have no value beyond a promise to impose higher taxes on
future workers. The annual surpluses that many thought were being used
to build up a reserve for baby boomers have been spent to fund other
government programs or to reduce the government debt.
The OASI and DI
Trust Funds.
Social Security has two trust funds: the Old-Age and Survivors
Insurance trust fund and the Disability Insurance trust fund. These
two trust funds are linked and are often referred to as a single trust
fund, the Old-Age, Survivors, and Disability Insurance trust fund, or
OASDI.
Despite the fact that there are two trust funds, most of the estimates
of Social Security’s finances use the combined OASDI trust fund, which
is an important distinction. For instance, according to the 2004
trustees report, OASDI will begin to spend more than it takes in by
2018. Considered separately, the OASI trust fund is also predicted to
begin to spend more than it takes in each year starting in 2018, but
the DI trust fund will begin to spend more than it takes in starting
in 2009.
In
addition to the two Social Security trust funds, there is a Health
Insurance (HI) trust fund that partially funds Medicare. The HI trust
fund is managed and invested in the same way as the OASI and DI trust
funds but is outside the scope of this paper.
The Trustees and
Their Annual Report.
The same trustees
manage the OASI, DI, and HI trust funds. Three of the six trustees are
Cabinet officials: the Secretary of the Treasury, Secretary of Labor,
and Secretary of Health and Human Services. The Secretary of the
Treasury serves as the managing trustee. In addition, the Commissioner
of Social Security is a trustee, and two public trustees are appointed
by the President and confirmed by the Senate for four-year terms. The
terms of public trustees John L. Palmer and Thomas R. Saving expired
in October 2004, but they can continue in their roles until the 2005
trustees report is released.
Every year, the trustees are required to issue a report that details
both the financial activities in the trust funds and the long-term and
short-term outlooks for Social Security’s programs. Available from SSA
both on-line and in published copies, these annual reports contain a
wealth of numbers, statistics, and predictions. In addition to the
numbers from the most recent year, the reports predict Social
Security’s financial status for both the next 10 years and the next 75
years.
Recently, the trustees have also developed a perpetual measure that
extends well beyond the 75-year measure. This is intended to respond
to critics who fail to understand that any reform that is based on the
75-year measure alone could leave the system on a path that would
result in huge new deficits just one year beyond that 75-year horizon.
The
report includes predictions based on the most likely economic scenario
as well as both more optimistic and more pessimistic outcomes. Some
analysts make the mistake of assuming that the three outcomes are
equally likely to happen. However, a deeper analysis shows that there
is only an extremely small chance that either the optimistic or the
pessimistic outcome will happen, while there is a very high chance
that the most likely outcome will occur. For that reason, the most
recent trustees reports include a stochastic analysis that shows the
probabilities of each outcome’s actually happening.
Often, press reports focus on the simplest statistics, such as the
year in which the trust funds are predicted to run out of assets.
However, a more careful examination reveals other important
information, such as the amount that Social Security owes in promised
benefits beyond what it can pay with payroll taxes. The report also
indicates the year in which the programs must begin to spend more than
they receive in payroll taxes. These are actually more important to
determining the programs’ ability to meet the needs of those who
depend on them.
The OASI Trust Fund.
The Old-Age and
Survivors Insurance trust fund—by far the larger of the two Social
Security trust funds—pays retirement and survivors benefits. In 2003,
the OASI trust fund had a total income of $543.8 billion. Of that
total, $456.1 billion (83.9 percent) came from payroll taxes; $12.5
billion (2.3 percent) came from income taxes paid on higher-income
retirees’ Social Security benefits; and $75.2 billion (13.8 percent)
came from interest paid on special-issue Treasury bonds in the trust
fund.
During 2003, the trust fund paid out $399.8 billion in benefits (73.5
percent of tax receipts) and $2.6 billion (0.5 percent) for
administrative expenses. The remaining $137.8 billion (25.3 percent)
was retained in the trust fund. As a result, the trust fund’s assets
grew from $1.217 trillion at the beginning of the year to $1.355
trillion at the end of 2003.[2]
The Disability
Insurance Trust Fund.
The Disability
Insurance trust fund—the smaller of the two Social Security trust
funds—pays disability benefits. In 2003, the DI trust fund had a total
income of $88.1 billion. Of that total, $77.4 billion (87.9 percent)
came from payroll taxes; $0.9 billion (1.0 percent) came from income
taxes paid on higher-income workers’ disability benefits; and $9.7
billion (11.0 percent) came from interest paid on special-issue
Treasury bonds in the trust fund.
During 2003, the trust fund paid out $70.9 billion (80.5 percent of
tax receipts) in benefits and $2.0 billion (2.3 percent) for
administrative expenses. The remaining $15.0 billion (17.0 percent)
was retained in the trust fund. As a result, the trust fund’s assets
grew from $160.4 billion at the beginning of the year to $175.4
billion at the end of 2003.[3]
The
disability program’s separate trust fund and tax structure, combined
with the completely different eligibility criteria for receiving
disability benefits, distinguish it from the retirement and survivors
program. The disability program is a true insurance program, while the
retirement and survivors program is much closer to a retirement
investment program.
How the Social
Security Trust Funds Differ from Real Trust Funds.
Private-sector trust
funds invest in real assets, ranging from stocks and bonds to
mortgages and other financial instruments. Assets are held only for a
specific purpose, and the fund managers are liable if the money is
mismanaged. Funds are managed in order to maximize earning within a
pre-agreed risk level. Investments are chosen to provide cash at set
intervals so that the trust fund can pay its obligations.
The
Social Security trust funds are very different. As explained by the
Office of Management and Budget (OMB):
The Federal budget meaning of the term “trust” differs significantly
from the private sector usage…. [T]he Federal Government owns the
assets and earnings of most Federal trust funds, and it can
unilaterally raise or lower future trust fund collections and
payments, or change the purpose for which the collections are used.[4]
Even
more important, the Social Security trust funds are “invested” only in
a special type of Treasury bond that can only be issued to and
redeemed by the Social Security Administration. These bonds cannot be
sold to the public to raise money. They are only a measure of what the
government owes itself. As the Congressional Research Service noted:
When the government issues a bond to one of its own accounts, it
hasn’t purchased anything or established a claim against another
entity or person. It is simply creating a form of IOU from one of
its accounts to another.[5]
As a
result:
These [Trust Fund] balances are available to finance future benefit
payments and other trust fund expenditures—but only in a bookkeeping
sense. These funds are not set up to be pension funds, like the
funds of private pension plans. They do not consist of real economic
assets that can be drawn down in the future to fund benefits.
Instead, they are claims on the Treasury, that, when redeemed, will
have to be financed by raising taxes, borrowing from the public, or
reducing benefits or other expenditures. The existence of large
trust fund balances, therefore, does not, by itself, make it easier
for the government to pay benefits.[6]
In
short, the Social Security trust funds are really only an accounting
mechanism. They show how much the government has borrowed from
Social Security but do not provide any way to finance future
benefits.
How Money Goes to
and from the Trust Fund.
An employer pays
taxes to the Treasury by periodically sending a check (or electronic
transfer) that includes both income taxes and payroll taxes. The
check is sent without distinguishing between payroll and income
taxes. There is also no indication of which individual employees’
taxes are being paid or how much those employees earned.
On
a regular basis, the Treasury estimates how much of its aggregate
tax collections are due to Social Security taxes and credits the
trust funds with that amount. No money actually changes hands: This
is strictly an accounting transaction. These estimates are corrected
after income tax returns show how much in payroll taxes was
actually paid in a specific year. In addition, the Treasury
credits the trust funds with interest paid on its balances and with
the amount of income taxes that higher-income workers pay on their
Social Security benefits.
To
pay benefits, the Social Security Administration directs the
Treasury to pay monthly benefits, and that amount is subtracted from
the total in the trust funds. Any remainder is converted into
special-issue Treasury bonds, which are really nothing more than
IOUs.
After the trust fund has been credited with the IOUs, Social
Security’s extra tax revenue is then spent by the Treasury just as
any other taxes are spent. If the federal budget is running a
surplus, that amount could be used to repay federal debt owned by
the public. Otherwise, it is spent on any other type of federal
program, ranging from aircraft carriers to education research.
Special Securities
Issued to the Trust Funds.
The Social Security
trust fund consists only of special-issue Treasury bonds. These
bonds are special in that they can only be issued to and redeemed by
the Social Security trust funds. They cannot be sold in the open
market.
The Social Security trust fund bonds pay the same interest rate as
regular Treasury bonds issued on the same day with the same maturity
date. When the bonds mature, they are rolled over into new bonds
that include both the original issue amount and any interest due.
The new bonds also pay the same interest rate as comparable Treasury
bonds.
Because these are special-issue bonds that are payable only to the
Social Security Administration, the SSA cannot sell them to a third
party to raise money to pay benefits. This reinforces the fact that
these bonds are really nothing more than IOUs from one branch of
government to another. They are not a real financial asset.
Until relatively recently, these bonds existed only as entries in a
record book. Now, however, when a new bond is issued, it is printed
on a laser printer located at the Bureau of the Public Debt office
in Parkersburg, West Virginia. The bond is then carried across the
room and put in a fireproof filing cabinet. That filing cabinet is
the Social Security trust funds.
How Trust Fund
IOUs Would Be Repaid.
At some point in the
future, probably starting about 2018, Social Security will start to
pay more in benefits than it receives from payroll taxes. At that
point, it will begin to cash in the bonds in the trust fund.
According to the most recent trustees report, Social Security will
cash about $5.7 trillion (in 2004 dollars) in special-issue bonds,
cashing the first special-issue bond in 2018 and the last bond in
2042.
According to the OMB, there are only four ways that Congress can
repay these bonds: raise other taxes, authorize the Treasury to
borrow the needed funds from the public, reduce spending on other
federal programs and use the savings to redeem Social Security’s
bonds, or simply reduce Social Security benefits. None of these
options is easy or attractive.
Determining Social Security Benefits
Social Security benefits are based on earnings averaged over most of
a worker’s lifetime. Most people know about Social Security’s
retirement benefits, but the program also pays benefits to disabled
workers. In addition, families can receive benefits under certain
circumstances. The formula that the agency uses to determine the
benefits for a worker or the worker’s family is complex.
Complicating matters even more are a number of special
circumstances that can alter those benefits.
What follows is a general analysis that is suitable for
policymakers. For individual cases, it would be wiser to seek
guidance from either the SSA or other sources.
When Can a Worker
Retire?
There are two answers to this question. A worker can begin to
collect Social Security retirement benefits as early as age 62 but
cannot begin to receive full retirement benefits until between ages
65 and 67. The exact age for full benefits depends on the worker’s
birth date. Workers born before 1938 can receive full retirement
benefits starting at age 65. The full retirement age increases by
two months per year for workers born between 1938 and 1942 and is 66
for those born between 1943 and 1954. The full benefits age then
increases by two months per year for those born between 1955 and
1959 and is 67 for anyone born in 1960 or after.
If
a worker decides to receive benefits starting at age 62, the monthly
benefits will be reduced by a set percentage for each month that the
worker receives benefits before full retirement age. As the full
retirement age increases from 65 to 67, workers who retire early
will receive an even greater reduction in their monthly benefits.
Currently, a worker who retires at 62 will receive 80 percent of the
full retirement age amount. This will eventually drop to 70 percent
for those with a full retirement age of 67.
Even after a worker reaches full retirement age, the worker’s
benefits continue to increase every month until that worker applies
to receive retirement benefits. This benefit growth continues until
age 70.
Qualifying for
Retirement Benefits.
Not everyone is
qualified to receive Social Security benefits. To qualify, a worker
must earn at least 40 quarterly credits. A worker earns one credit
by earning at least $900 in a three-month period and paying Social
Security taxes on that amount. Workers who earn $3,600 during a year
earn four credits.
The amount of income required to earn a credit is adjusted annually,
but this does not affect credits that have already been earned. Once
a worker has earned the required 40 credits, he or she is
permanently qualified. However, the level of benefits depends on
worker’s income history.
The Disability Insurance program has similar requirements, but the
number of credits necessary to qualify varies depending on the age
at which the worker becomes disabled. In general, the younger the
person who is disabled, the lower the number of credits required to
qualify for benefits.
The General
Formula for Retirement Benefits.
Retirement benefits
are based on a worker’s highest 35 years of earnings. Those wages
are indexed so that all 35 have the purchasing power of the year
when the person retires. The worker’s Average Indexed Monthly
Earnings (AIME), or average monthly salary, is calculated using the
35 years of indexed earnings. The AIME is then run through a formula
that calculates benefits equal to 90 percent of AIME up to a certain
level of monthly income, 32 percent of AIME from that level to a
higher point, and 15 percent of the remaining AIME.
The dividing points between the three payment levels are known as
“bend points.” The three payment levels are added up to find the
worker’s monthly Social Security retirement benefit. Both steps are
detailed below.
Determining
Average Indexed Monthly Earnings (AIME).
Retirement benefits
are calculated using a worker’s highest 35 years earnings. They do
not have to be consecutive years. If the worker has an earnings
record for more than 35 years, only the 35 years of highest earnings
are included in the calculation; years with lower earnings are
dropped. Only those earnings on which the worker paid Social
Security taxes are counted. Thus, if the worker earned $100,000 in
2004, that year’s income would be counted as $87,900 for determining
benefits, since the worker only paid Social Security taxes on the
lower amount.
Except for the two years immediately prior to retirement, earnings
for previous years are indexed so that all years are measured by the
same ability to purchase goods and services; the two years
immediately before retirement are not indexed. This indexing
increases past earnings to account for both inflation and increases
in average wage growth. For instance, it would take $12.05 in 2004
dollars to equal $1.00 earned in 1951, and $1.61 to equal $1.00
earned in 1990.
Once the 35 years of highest earnings are determined, they are
totaled and divided by 420 (the number of months in 35 years). The
result is the Average Indexed Monthly Earnings, which is used to
calculate Social Security benefits.
Some jobs—usually for state or local governments—are not covered by
Social Security, and earnings for those jobs are not included in
calculated AIME. For the purposes of determining Social Security
benefits, those years count the same as if the worker was not
employed.
If
a worker did not work for a full 35 years— perhaps due to raising a
family or because of illness—the missing years are counted as
zeros. For example, if a worker is either employed for only 25 years
or worked in a job covered by Social Security for only 25 years, the
indexed earnings from those 25 years are added together and divided
by 420. This lowers that worker’s AIME to account for the missing
years. Social Security benefits earned by state and local
government workers are adjusted in other ways, as explained in the
sections on the Government Pension Offset and the Windfall
Elimination Provision.
Wage Indexing vs.
Price Indexing.
In creating AIME, a
worker’s past wages are indexed to bring them to the same level as
today’s earnings. There are two general ways to index past earnings
and potentially dozens of variations on these two that would create
results that lie in between the two general methods. This
calculation is done only once in a worker’s life—when he or she
first applies for Social Security benefits. Once the worker’s
initial monthly benefit has been determined, it is price indexed in
each successive year to protect the retiree from inflation.
Price indexing is based upon the Consumer Price Index (CPI) and
compensates for inflation. Price indexing benefits ensures that they
maintain their constant purchasing power. In this case, if inflation
had increased by 5 percent since last year, simply multiplying the
previous year’s benefit by 1.05 would preserve the retiree’s ability
to buy the same amount of goods as last year.
By
contrast, wage indexing is based on the growth in average wages in
the economy over a set period of time and is supposed to allow
workers to retire with the same standard of living. The growth in
average wages includes both inflation and growth in the overall
economy. As a result, wage indexing almost always results in a
higher AIME than price indexing. Social Security uses wage indexing
only when calculating AIME, determining the annual level of bend
points in the benefit level, and determining the annual level of the
payroll tax earnings cap.
The difference between the two forms of indexing can be important.
If a worker had been a bricklayer throughout his or her career and
earned $4.00 per hour in 1980, indexing that amount for inflation
(an increase of 129.3 percent) would result in an indexed wage of
$9.17 per hour.[7]
On the other hand, indexing for average growth in
wages (an increase of 172 percent) would result in $10.88 per hour.[8]
While it is true that $9.17 in 2004 would buy the
same amount as $4.00 in 1980, the average wage for a bricklayer
could have increased to something closer to $10.88 per hour in
2002.
Wage indexing allows retirees to take advantage of the increase in
the standard of living over their working careers. However, it is
often criticized as giving workers a retroactive credit for
improvements in the economy. In other words, the worker’s 1980
wages are being measured according to the economy of 2004 rather
than according to the 1980 economy in which they were earned.
The key difference is in replacement rates. The replacement rate is
the proportion of a worker’s average monthly earnings that is paid
by that worker’s Social Security retirement benefit. Currently,
Social Security pays average-income workers a retirement benefit
that is equal to between 40 percent and 45 percent of their average
monthly earnings. Lower-income workers generally receive a higher
proportion of their average monthly earnings, while higher-income
workers receive a lower proportion.
With wage indexing, these replacement rates will remain roughly
stable. On the other hand, changing to price indexing will gradually
reduce the replacement rates. While this would bring promised Social
Security benefits closer to what the program can afford to pay, it
would also require workers to make up the difference from either
savings or some other form of retirement plan. Most experts believe
that a retiree needs an income equal to roughly 70 percent of
pre-retirement income for a comfortable retirement.
Annual COLA
Increases.
Once a worker’s monthly benefits have been determined, they are
increased every year by the rate of inflation. This Cost of Living
Adjustment (COLA), is intended to preserve the purchasing power of a
recipient’s benefits. The amount of the annual increase is
announced each October and takes effect the following January.
The COLA is based on the inflation rate for the preceding 12 months
from October 1 to September 30. For example, in October 2004, the
SSA announced a COLA increase of 2.7 percent for all checks issued
after January 1, 2005. This increase was based on the change in
CPI-W from October 1, 2003, through September 30, 2004.
The SSA currently uses the Department of Labor’s Consumer Price
Index for Urban Wage Earners and Clerical Workers (CPI-W) to measure
inflation, but the law allows it to substitute other inflation
indexes or the annual increase in average wages under some
circumstances.
Using Bend Points
to Calculate the Monthly Benefit.
Once an AIME has been
determined, the SSA calculates a worker’s monthly retirement
benefit using a formula that pays a higher benefit relative to
income to lower-income workers than to higher-income workers. In
2004, Social Security paid 90 percent of the first $612 of a
worker’s AIME, 32 percent of the AIME amount between $612 and
$3,689, and 15 percent of any AIME amount over $3,689. The dividing
points in this formula are called “bend points.” The SSA adjusts the
bend points each year.
The bend points ensure that a lower-income worker receives Social
Security retirement benefits that are comparatively higher relative
to pre-retirement income than upper-income workers receive. For
example, a worker with an AIME of $4,000 (or an average annual
income of $48,000) would receive 90 percent of the first $612
($550.80); 32 percent of the amount between $612 and $3,689
($984.64); and 15 percent of the amount between $3,689 and $4,000
($46.65). Thus, the worker’s monthly benefit would be $1582.09, or
about 40 percent of AIME.
On
the other hand, a worker with an AIME of only $1,200 (or an average
annual income of $14,400) would receive 90 percent of the first $612
($550.80) and 32 percent of the amount between $612 and $1,200
($188.16), for a total monthly benefit of $738.96. This lower
monthly benefit amount would equal 61 percent of his or her AIME.
The Spousal
Benefit.
In addition to the retirement benefits that a worker can receive,
the worker’s spouse can also receive a benefit in some
circumstances. Almost all spouses who qualify for the full benefit
come from single-earner families in which one spouse was employed
and the other stayed at home to care for the family. The spousal
benefit is equal to 50 percent of the employed spouse’s benefit,
which means that such families could receive a total Social Security
income of 150 percent of the working spouse’s benefit while both are
still alive.
The “dual entitlement rule” prevents spouses who qualify for their
own Social Security retirement benefits from receiving both their
own benefits and a spousal benefit. An exception is made if the
lower-earning spouse’s benefits are less than 50 percent of the
higher-earning spouse’s benefits. In that case, the lower-earning
spouse would also qualify for a spousal benefit equal to the
difference between his or her retirement benefits and 50 percent of
the higher-earning spouse’s benefits.
Some special circumstances—for example, if one spouse was employed
by a state or local government that is not part of Social
Security—can make it appear that someone qualifies for spousal
benefits even though they may have substantial income or retirement
benefits from the non–Social Security job. The Government Pension
Offset addresses this circumstance and limits spousal benefits to
families that truly qualify for it.
Survivors
Benefits.
The amount of the survivors benefits paid to spouses and children
under the age of 18 depends on the earnings history of the deceased
worker. The same formula that calculates retirement benefits is
also used for survivors benefits. They are usually calculated as a
percentage of the benefit for which a worker would have been
eligible at the time of death.
Surviving spouses near retirement age receive a benefit that is
based on the worker’s retirement benefit. If the worker began to
receive benefits at a full retirement benefits age, the surviving
spouse will receive an amount equal to 100 percent of the worker’s
benefits. This is also true if the worker died before begining to
receive Social Security. However, if the surviving spouse is also
entitled to receive benefits, he or she will receive only the larger
of the two amounts. The survivor will not receive both the worker’s
benefit and his or her own benefit.
If
the deceased worker began to receive a reduced amount of retirement
benefits before full retirement age, the surviving spouse will also
receive a reduced monthly benefit. The exact amount depends on the
survivor’s age and the level of the worker’s benefit. A surviving
spouse can receive benefits as young as age 60, but in that case
would receive only 71.5 percent of the worker’s full retirement-age
benefit. As the full retirement age increases, this percentage will
also change.
In
addition to the monthly benefit, surviving spouses receive a
one-time $255 death benefit. This benefit is payable only to spouses
or children eligible to receive benefits.
