One of the most common misconceptions I come across as a retirement planner is how Social Security benefits are calculated. The confusion appears to result from thinking pension benefits and Social Security are determined the same way.
Many employers use some variation of the average annual earnings over five years. They often pick the highest five years for the average. The benefit is frequently a percentage of average earnings based on years of service.
How your Social Security benefits are supposed to be calculated
Social Security uses the highest 35 years of earnings going back to 1951 to compute average earnings. An inflation factor is applied to each of those 35 years to adjust the income to today’s dollars. This calculation becomes the average indexed monthly earnings (AIME).
Social Security was designed to provide a retirement benefit based on a worker’s career earnings.
The AIME calculation is similar to the first step used by pensions but the second step is quite different. Social Security benefits are tilted to favor the lower end of AIME by using bend points to determine the primary insurance amount (PIA). These dollar amounts are the “bend points” of the 2016 PIA formula:
- 90% of the first $856 of his/her average indexed monthly earnings, plus
- 32% of his/her average indexed monthly earnings over $856 and through $5,157, plus
- 15% of his/her average indexed monthly earnings over $5,157.
The resulting benefit amount will be affected by the final component of the calculation—age. Benefits are penalized when the worker retires before normal retirement age. A worker can draw Social Security benefits at age 62, but their benefit will be reduced by approximately 0.56% for each month before normal retirement age. Most pensions handle the benefit similar to Social Security by reducing monthly income if the worker starts their pension before age 65.
Social Security benefits are an important component of retirement planning. Understanding how your benefit is determined can help you strategize the best way to maximize this benefit.