Breaking Down a Key Component in Retirement Planning

Last time we looked at the structure and function of the Social Security Trust Fund.  Next, I would like to explore just how benefits paid from the fund to individuals are calculated.

Social Security benefits play a crucial role in providing financial stability and support to millions of retired workers, as well as disabled individuals and the surviving family members of deceased workers in the United States. The calculation of these benefits is a fairly complex process that takes into account various factors like earnings history, age and retirement age. Let’s explore some of the intricacies.

Earnings History

At the core of the Social Security benefit calculation lies an individual’s earnings history.

Throughout our working years, we contribute to the Social Security system through payroll taxes, which are used to fund the benefits program. The Social Security Administration (SSA) maintains a record of our earnings, referred to — somewhat unimaginatively —  as the “earnings history.” This history is crucial in calculating the average indexed monthly earnings (AIME), which serves as the foundation for determining our benefit amount.

Average Indexed Monthly Earnings (AIME)

The AIME is calculated by adjusting an individual’s historical earnings for inflation using the Average Wage Index (AWI) published by the Social Security Administration.

The AWI reflects the growth in national wages over time. To calculate the AIME, the highest-earning years (up to 35 years) from an individual’s earnings history are selected. If an individual has less than 35 years of earnings, zeros are included for the remaining years.

Once the selected earnings are determined, they are adjusted for inflation using the AWI. This adjustment ensures that earnings from different years are comparable and reflect their relative purchasing power. After adjusting the earnings, they are divided by the total number of months in the selected years to derive the AIME.

Primary Insurance Amount

The AIME is further used to calculate the Primary Insurance Amount (PIA), which represents the monthly benefit an individual is eligible to receive at their full retirement age. This age is typically between 66 and 67, depending on an individual’s birth year.

To calculate the PIA, a formula consisting of three bend points is applied, which are predetermined percentages of the AIME. These bend points are adjusted annually to account for changes in average wages. The formula is structured in a progressive manner, meaning that lower-earning individuals receive a higher replacement rate compared to higher-earning individuals.

The formula involves multiplying different portions of the AIME by corresponding percentages. For example, for individuals reaching retirement age in 2024, the formula multiplies 90% of the first $996 of the AIME, 32% of the amount between $996 and $6,002, and 15% of the amount exceeding $6,002. The resulting amounts are summed up to calculate the PIA.

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So there you have it. The calculation of Social Security benefits is a multifaceted process that considers an individual’s earnings history, the average indexed monthly earnings, and the primary insurance amount. Comprehending these components is essential for us to understand how our benefits are determined, enabling us to make informed decisions regarding retirement planning and financial well-being.

By Steven Roberts