How is my Social Security benefit calculated?

Dear Rusty: I appreciate your recent article dispelling the myth that politicians have stolen Social Security money. As a CPA, I dispel this myth repeatedly to clients who falsely claim SS funds have been raided. But another thing I deal with often is how SS benefits are calculated. I know the formula for determining each person’s benefit amount is complex, but I have had to explain numerous times that those who put the most into Social Security get the lowest rate of return and those who put the least in get the highest return based on the way the benefit formula is structured. I get tired of people complaining that monthly Social Security payments are higher for retired doctors and other highly paid individuals. Can you please explain how Social Security is weighted in favor of lower income workers? Signed: Tired of the Misunderstandings

Dear Tired: Please don’t be frustrated. Because of the program’s complexity, Social Security is prone to misunderstanding and educating the misinformed is an important professional duty we share. Here’s how each person’s SS benefit is determined:

The first thing to know is that each person’s SS retirement benefit is not based on their financial contributions to the program. Social Security’s purpose is to provide a benefit which replaces a portion of the person’s pre-retirement income, so the SS benefit is based on actual lifetime earnings, not on the payroll taxes withheld from those earnings.

Social Security has your lifetime earnings record (obtained annually from the IRS) and that record determines your “primary insurance amount” or “PIA.” Your “PIA” is initially determined in your eligibility year (usually age 62) and is the amount you will get if you claim for benefits to start exactly at your full retirement age.

To develop your PIA, Social Security first adjusts (indexes) each year of your lifetime earnings (up to the annual payroll tax cap) to account for inflation. They then select the 35 inflation-adjusted years in which you earned the most, from which they compute your average monthly earnings over your lifetime (this is called your Average Indexed Monthly Earnings, or “AIME”).

They then break your AIME into three segments, the first of which includes a majority of — and possibly all of — your AIME. They then take a percentage of each segment and total those three amounts to determine your PIA. The first segment is the largest and 90 percent of that first segment contributes most of your PIA. Smaller percentages of the other two segments (32 percent and 15 percent respectively if your AIME is higher), are then added to the first computation to arrive at your full PIA — the amount you get if you start benefits in the month you reach your FRA. Note that since most of the PIA comes from the first large segment of each person’s AIME, lower income workers get a higher percentage of their lifetime average monthly amount.

Since benefits are based on earnings, those with lower lifetime earnings do, indeed, get a smaller benefit than those with higher average lifetime earnings, but the percentage of pre-retirement replacement income lower income workers receive is higher than for those with higher monthly average lifetime earnings. The Social Security benefit for lower income workers is typically about 40 percent of their pre-retirement average monthly income, while those with higher lifetime average earnings may get a benefit as little as 20 percent of their average monthly pre-retirement earnings. In that sense, the Social Security benefit formula is progressive and weighted in favor of lower income workers. Nevertheless, albeit a smaller replacement percentage, higher income workers receive a higher monthly SS benefit because of their higher lifetime earnings. Even so, those higher earners did, indeed, contribute more payroll taxes from their higher earnings.

So, each person’s SS retirement benefit amount is a percentage of their pre-retirement income. Coincidently, those with higher pre-retirement income also contributed more to the Social Security program than did those with lower earnings. But their higher SS benefit amount is based on their higher pre-retirement earnings, not on payroll taxes paid from those higher earnings.