Your Guide to Social Security, Part Two

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

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Here is the second of three columns explaining how Social Security benefits are determined, and how they are affected by changing wage and inflation levels. I was led through this process by the Social Security Administration's chief actuary, Stephen C. Goss. The first installment explained how the agency calculates the wage base that it uses to determine each person's individual benefit.

This wage base is called the average indexed monthly earnings. The individual benefit is called your primary insurance amount (PIA). Regardless of when you elect to begin receiving Social Security benefits—as early as age 62 or as late as age 70—the money you will get each month will range from 75 percent to 132 percent of your PIA.

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Social Security was designed to provide its strongest support to lower-income workers. It caps the contributions you make into it based on your earnings. This year, for example, the employee share of payments is 6.2 percent up to an annual ceiling of $106,800; there is a separate Medicare tax of 1.45 percent, with no earnings ceiling. The earnings ceiling changes with inflation each year. It was $76,200 in 2000, $51,300 in 1990 and only $25,900 in 1980. Because there was no price inflation in the year ended last September, there will be no change to this ceiling in 2010.

Beyond these caps, the program's payout calculations are weighted to aid lower-income earners and people who have not worked their entire lives. As the first column explained, your Social Security benefits are based on your 35 highest years of earnings, indexed for wage inflation. If you've worked fewer than 35 years, Social Security uses a zero for each of those years. So, for example, a person with 20 years of earnings history will have a 35-year average that includes zeros for 15 of those years. This obviously pulls down that person's averaged indexed monthly earnings.

To help compensate, the program translates a person's average indexed monthly earnings (AIME) into their primary insurance amount by using a series of calculations. For the first $744 of a person's AIME, 90 percent becomes part of their PIA. For the next band of AIME—from $744 to $4,483—32 percent becomes part of the PIA. And for any AIME above $4,483, only 15 percent becomes part of the PIA. So, while people earning $100,000 a year do benefit from higher Social Security payments than people with lower earnings, only a small percentage of those higher earnings applies to their Social Security benefit. The formula is what economists describe as progressive, meaning that it is weighted toward lower-income workers.

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The $744 and $4,483 amounts are called bend points by Social Security, and they are adjusted each year to reflect changes in the national average wage index. As explained in the first column of this series, the wage index is calculated each year by adding up the value of all W-2 and 1099 self-employment earnings statements in a year and dividing them by the number of people filing statements. The resulting average wage is then compared with previous years' average wages to develop an index. There is a two-year lag, Goss explained. The change in bend points from 2008 to 2009 is based on the change in average wages from 2006 to 2007. The bend points 30 years ago, by comparison, were only $180 and $1,085. The 90, 32, and 15 percent brackets are set in law and do not change each year.

(Social Security uses a similar approach to determine a family's maximum benefits, a situation that usually happens when one or more children is receiving Social Security benefits. The family maximum is determined using three bend points and four brackets. For 2009, the formula adds 150 percent of the first $950 of the AIME of the person whose benefits are being drawn upon, 272 percent of the AIME between $950 and $1,372, 134 percent of the AIME between $1,372 and $1,789, and 175 percent of the AIME above $1,789. There is a slightly different formula used for the family maximum of a disabled worker.)

Each year, Social Security calculates its estimated PIA for you, based on your current earnings history. The figure is included in an annual mailing called "Your Social Security Statement." It's the monthly payment you would receive if you continue working and do not elect to begin receiving benefits until you've reached what Social Security calls your full retirement age.

Your PIA is determined by your own lifetime earnings. If you're 60 or older, any future earnings you make will not be adjusted downward for any national wage inflation that's occurred since you turned 60. That might make it easier for those years to qualify as among your 35 best earnings years. And the boost to your primary insurance amount could be helpful.

During a recession, with incomes falling and unemployment rising, the odds are that national annual wage changes will be modest. So, if you're nearing an age at which you are entitled to receive Social Security benefits, national wage changes will not by themselves boost the primary insurance amount presented in your most recent annual statement from Social Security. Also, keep in mind that it takes Social Security two years to factor in the impact of changing wage patterns on your benefits. So, you should see some increase in your AIME next year because it will be based on 2008 wages.

Part III: Deciding when to begin receiving Social Security benefits.

[See Poor Social Security Knowledge Has Big Costs.]