Your Guide to Social Security, Part One

Understanding how benefits are set will help you make the best decisions for your retirement needs.

By + More

Social Security is our most important retirement benefit. Never intended as a source of primary retirement income, it has become just that for most retirees. And when 401(k)s, IRAs, and other retirement funds took such a drubbing in the 2008-2009 stock market dive, the relative importance of Social Security became even greater.

[See Best Affordable Places to Retire.]

Yet, Social Security receives little attention compared with the attention paid to private retirement plans—401(k)s, IRAs, target date funds, Roth IRA conversions, and other retirement investments. With the clock winding down on a challenging year and an even tougher decade, it's a good time to review the long-standing rules that drive Social Security payments. This understanding might help guide your plans for using this fundamental retirement benefit, and shed light on how benefits will be changing in future years.

It may help to begin this trip with a cup or two of coffee, brewed strong. There is just no escaping the presence of a lot of numbers when dealing with Social Security. For the truly motivated, it also will help if you go find the most recent "Your Social Security Statement" that you receive each year from the Social Security Administration. This is the most significant retirement document that most people receive. It lays out the record of your annual earnings and explains the benefit amounts to which you're entitled, including how those amounts will change based on the age at which you decide to begin taking benefits.

More than 25 years ago, Social Security benefits began being indexed to inflation. Using the rise in consumer prices in the 12 months ending each September, Social Security applied a cost of living adjustment, or COLA, to the following year's benefits. This has been a true lifesaver to recipients, and never more so than in 2009. That's because the spike in gasoline prices in 2008 contributed to a 5.8 percent COLA for 2009 benefits—the largest one-year boost in the COLA's history. As the economy continued to tank in 2009, so did the prices of fuel and lots of other items, and consumer inflation largely disappeared in the 12 months ended last September. So, there will be no Social Security COLA in 2010 —another first for the program.

This lack of inflation not only affects current Social Security recipients. It turns out that the basic level of benefits for newly eligible Social Security recipients also is affected by inflation levels. Understanding that impact requires a trip deep into the rules and formulas governing Social Security benefits. Fortunately, we have a great guide—Stephen C. Goss, chief actuary at the Social Security Administration.

Social Security benefits are based on wage earnings, and exclude income from investments and other holdings. People must have earned wages in at least 40 quarters to qualify for benefits, and they must have earned at least a certain amount of money in a quarter for it to be counted. In 2009, the minimum quarterly earnings amount was $1,090. It rises each year to reflect changing wage and price levels; in 1979, for comparison, it was only $260.

For people with enough earnings to qualify, Social Security then takes the average of their 35 highest years of wage earnings. But it doesn't just take the actual amount of money earned each year, Goss explained. It engages in extensive calculations to equalize the value of wages over time. Given the long-term effect of inflation, for example, $10,000 earned in 1980 is worth a lot more than $10,000 earned in 2009.

[See Best Places to Retire.]

The equalization process involves looking at every IRS W-2 and, for self-employment earnings, Form 1099, that is filed by taxpayers each year. I always thought my W-2s were only of interest to the IRS but Goss says those records are actually processed for the IRS by Social Security. "We get all the W-2s and we process them, and we add up all your wages," he says. "We do that for everybody in the country who has wages reported. We look at the total amount of wages and the total number of people reporting wages." Dividing the two numbers produces a national average wage for each year, and tracking the changes of that number over time produces a national average wage index.

Going back to our example of wages earned in 1980, Social Security would look at the ratio of the average national wage in 2009 and the national average wage in 1980 and adjust the value of what you earned in 1980 up to 2009 levels. It then would take the 35 highest annual adjusted earnings years and calculate an average.

Up until people reach the age of 60, this 35-year average is adjusted each year to reflect inflation and changing national wage levels. In the year in which you turn 60, Social Security stops indexing your wages. Here's why. People can elect to begin receiving Social Security benefits as early as the age of 62, Goss explained. There's a two-year lag between when people report wage earnings on their W-2s and when the national wage index is calculated. The 2009 index, for example, is announced in late 2008, and is based on W-2s for 2007 earnings. So, in order for the agency to calculate the benefits of someone reaching the age of 62 in 2009, its latest wage information is based on how much money the person earned through 2007, when they turned 60.

Many people, of course, continue to work after they are 60 years old. Their wages for those years are not adjusted for inflation, and are compared with the wage-adjusted years to determine the top 35 years. This process continues until the year in which a person elects to begin receiving benefits. Once that happens, the 35 highest earnings years are averaged, the result is divided again by 12, and the agency determines a person's average indexed monthly earnings. This is a key figure, Goss said, and "becomes in effect your long-term career earnings level."

Part II. How benefits are calculated.

[See Tips on Social Security Claiming Strategies.]