How a Social Security benefit is calculated (Part 1).
By Duane J. Silbernagel
There appears to be a lot of unnecessary confusion surrounding how a social security benefit is calculated. From my general research, there is also a plethora of misinformation out there for individuals to find. So I’ve decided that I’ll put a short series of Social Security articles, with the intent that this will aid the readers in understanding exactly how their Social Security benefit will be calculated when they actually start drawing on Social Security.
Some readers may be the very analytical type (and through the series, we’ll get to all the formulas that you can plug into your customized spreadsheets – I can mock, because I am one of those as well), while others may just be interested in having an understanding of how exactly the government comes up with this mysterious number they’ll pay you for your life.
In order to know how the benefit is calculated, you first must understand how you become eligible for a benefit.
As you’ve progressed through your working career you earn working credits. You can earn a maximum of four (4) credits per year. In 2015, to earn one (1) credit, you must earn $1,220. If, at any point in 2015, – you earn $4,880 (or more), you will receive the max number of credits for the year. It doesn’t matter if that amount (which is indexed on a yearly basis) is earned over the course of the calendar year, or all in December.
When it comes to Social Security, terminology is very important. So here are some terms that I’m going to be using frequently, abbreviations and their associated definitions and meanings, pertaining to Social Security:
Primary Insurance Amount (PIA):
The monthly amount payable if you are a retired worker who begins receiving benefits at full retirement age or if you’re disabled and have never received a retirement benefit reduced for age.
Full Retirement Age (FRA):
The age at which a person may first become entitled to full or unreduced benefits based on age. It’s based on the year in which you were born:
Average Indexed Monthly Earnings (AIME):
A worker’s average indexed monthly earnings are calculated on the 35 years where you made the most money, indexed into today’s dollars by an inflation factor which can be found in Social Security Administration website. For those at home with your spreadsheets, these indexed numbers can potentially change yearly. These highest 35 values are then added together, and divided by 35 (arithmetic mean or average). This number becomes your AIME.
Note: the highest possible AIME in 2015, based on the math, is $8,920.
After calculating the AIME, the Social Security Administration follows another formula that is predicated on what are known as “bend points.” These will adjust yearly. The numbers provided will be strictly for 2015 and subsequently can be found at: http://www.ssa.gov/oact/cola/piaformula.html
The first bend point: $826
The second bend point: $4,980
2015 AIME will not exceed: $8,920
To convert your AIME to your monthly benefit (at FRA) the Social Security Administration then uses a formula modeled in the following table:
PIA Formula Bend Points
The first $826 of your AIME you receive 90% of toward your PIA.
If the AIME is greater than $ 826, you receive 32% of that excess amount – through AIME of $4,980. Any AIME of $4981 or more, you receive 15% of that.
If one crunches the numbers through (as shown above), the maximum benefit that an individual retiring at FRA this year would receive is $2,663 (sum of the Monthly Benefit Formula column).
Hopefully you found this article informative and interesting. Please do not become overwhelmed. These calculations can get confusing and complicated, very quickly. While it may or may not be important – to you personally – to understand the exact science behind this formula, it is vitally important to make ensure the accuracy of earnings reported to the Social Security Administration. These numbers come via the Internal Revenue Service. On a yearly basis I would encourage you to compare the numbers as reported on work history through the Social Security Administration and to the numbers reported on your taxes to the IRS.
Next week we will expand on Social Security by looking at the factors that go into filing for your benefit early. If you’d like to find out more about me, have an idea you’d like me to write about or would simply like to contact me – visit my website: www.duane.wrfa.com.
Thank you for reading.
This information has been prepared on the basis of publicly available third party source material believed to be reliable but it is not guaranteed by Waddell & Reed. Waddell & Reed is not affiliated with the Social Security Administration.
This article is meant to be general in nature and should not be construed as investment or financial advice related to your personal situation. Waddell & Reed does not provide legal or tax advice. Please consult with a professional regarding your personal situation prior to making any financial related decisions.
Duane Silbernagel is a Financial Advisor in Lincoln City, Oregon offering securities through Waddell & Reed, Inc., Member FINRA and SIPC. He can be reached at (541) 614-1322, via email at DSilbernagel@wradvisors.com.