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Entitlement Math

 October 20 2016     Anna Pfaehler
Client A: “I’ve worked my whole life, earning far more than Client B. Why is my benefit not larger than his?”

Two reasons: 

  1. Wages subject to Social Security are capped. In 2016, only the first $118,500 of earned income is subject to Social Security taxes (FICA). The income used to calculate your Social Security benefit is likewise caped. Someone who earns $350,000 this year will only earn $118,500 for the purpose of calculating their Social Security.
  2. Social Security was designed to be a safety net and the benefit calculation is skewed to be more beneficial to those with lower average earnings over their lifetime. 

The calculation for Social Security benefits starts with a taking an average of your inflation-adjusted earnings over 35 years, called Average Indexed Monthly Earnings (AIME). Then a series of breakpoints is applied to your AIME amount. The first $856 of average monthly earnings is multiplied by 90%. The next $4,301 is multiplied by 32% (earnings between $856 and $5,157). The balance of your average monthly earnings is multiplied by 15%. This determines your Primary Insurance Amount (PIA) which is the benefit you receive at full retirement age. 

For example, assume Client A is a high-earner and has an AIME of $9,500. Her benefit is: 

    $856 x 90% =      $770.40
+ $4,301 x 32% =    $1,376.32
+ $4,343 x 15% =    $651.45
    PIA                       $2,798.17

In this case, Social Security replaces about 29.5% of Client A’s average monthly earnings.

Now assume Client B’s AIME is a more modest $5,000. His benefit is: 

    $856 x 90% =     $770.40
+ $4,144 x 32% =   $1,326.08
   PIA                      $2,096.48

In this case, Social Security replaces about 41.9% of Client B’s average monthly earnings. 

Because of the breakpoints, higher earnings have a smaller impact on your benefit calculation. Every $1 increase in average earnings beyond $5,157 only boosts your benefit by $0.15. Furthermore, anything beyond the cap does not figure into the calculation at all. This is why someone who has a high-paying career might have benefits close in size to those of someone who has earned significantly less every year. In our example, although Client A has earned $4,500 more per month on average than Client B, Client A’s benefit is only $701.74 greater.

This outcome is by design. Social Security is meant to provide economic security in old age. Presumably, those who have earned more have had greater opportunity to save and should be better equipped to create their own economic security in retirement.