Social Security is a major source of income in retirement, but the amount you receive in benefits is based on a complex calculation that includes the use of bend points. Do you know what bend points are? If you don't, you could end up disappointed with the amount of money you end up collecting from Social Security in retirement.

Figuring out your monthly average income

Before you learn about bend points, it helps to understand how Social Security calculates your average indexed monthly earnings (AIME).

A shrugging woman in front of a chalkboard that's covered with question marks.

IMAGE SOURCE: GETTY IMAGES.

When calculating your AIME, Social Security adjusts your historical annual earnings for inflation using its average wage index (AWI). Specifically, Social Security indexes your past earnings depending on the year in which you turn 62, which is the soonest you can begin collecting benefits. Because there's a lag time to updating AWI, indexing always relies upon the AWI figure from two years prior to the age you turn 62, or your age 60 AWI. Therefore, if you turn age 62 in 2018, then your earnings would be indexed to 2016's AWI, which is $48,642.15.

To adjust your historical income using 2016's AWI, divide your age 60 AWI, or $48,642.15, by the AWI for each year you had earnings. This results in an indexing factor for each year. Then, multiply your historical earnings by every year's corresponding index factor to adjust them into 2016 dollars. If you're curious, you can view historical AWIs and index factors on Social Security's website.

Let's say you earned $42,305 in 2008 and you'll turn 62 in 2018. Social Security will adjust your 2008 earnings by dividing $48,642.15 by 2008's AWI of $41,334.97 to get an indexing factor of 1.1768. It then multiplies $42,305 by that factor, giving you an adjusted 2008 income of $49,784.

EXAMPLES OF EARNINGS BEFORE AND AFTER INDEXING
Year Earnings Index Factor Indexed Earnings
2008 $42,305 1.1768 $49,784
2009 $41,787 1.1948 $49,927
2010 $42,897 1.1672 $50,070
2011 $44,368 1.1317 $50,213
2012 $45,884 1.0975 $50,357
2013 $46,603 1.0836 $50,500
2014 $48,394 1.0465 $50,644
2015 $50,220 1.0113 $50,787
2016 $50,931 1 $50,931
2017 $53,880 1 $53,880

Table data source: Social Security Administration.

After Social Security adjusts your historical earnings, it then adds up your 35 highest years of income and divides that sum by 420, which is the number of months in 35 years. The end result is your average indexed monthly earnings, or your AIME.

The impact of bend points

On average, Social Security replaces about 40% of the average workers pre-retirement income. However, the program is designed to replace more of the income of a low earner than a high earner, and that's where bend points come into play. Bend points are income thresholds that are used to effectively reduce your AIME to the primary insurance amount (PIA) you'll receive from Social Security at full retirement age, or the age at which you can receive 100% of your monthly benefit. 

More specifically, when calculating your PIA, you only get credit for a certain percentage of your AIME up to each bend point, and those percentages are fixed by law.

FIXED PERCENTAGES OF INCOME USED IN BEND POINTS CALCULATION

Up to first bend point

Between First and Second Bend Point

Above Second Bend Point

90%

32%

15%

The income thresholds that trigger bend points, however, change annually based on changes in AWI (there's a two-year lag here, too). In 2018, the first bend point occurs at $895 and the second occurs at $5,397. That's up from $885 and $5,336, respectively, in 2017 because AWI increased by about 1.13% between 2015 and 2016.

Therefore, when calculating your PIA in 2018, Social Security will give you credit for 90% of your AIME up to $895, 32% of your AIME between $895 and $5,397, and only 15% for any AIME above $5,397.

For instance, if your AIME is $5,500, the bend point calculation would look like this:
.9(895) + .32(5397-895) + .15(103) = $2,262

In this scenario, your PIA would equal 41% of your AIME. However, the percentage of income that Social Security replaces could be much different for someone with a much lower or higher AIME. For instance, someone with an AIME of $1,500 would receive 67% of their AIME in benefits at full retirement age.

What else you should know

Social Security's got a problem on its hands. It already is paying out more in benefits than it collects in payroll taxes, and the trust fund it's relying upon to close the gap is expected to run dry in 2034, triggering an across-the-board 25% cut to benefits.

The prospect of a 25% pay cut to retirees won't be popular, but neither are fixes being proposed in D.C. to repair the problem. Changing bend points and shifting away from the AWI to other inflation measures are among the ways lawmakers may try to protect Social Security, so would-be retirees will want to pay close attention to Congress in the coming years. After all, any slight changes to these formulas could have a big impact on your lifetime benefits.

The Motley Fool has a disclosure policy.