Do you know how much you're going to get in Social Security? Probably not. According to a recent survey by Nationwide, 63% of would-be retirees confess they don't know how Social Security works, and even more scary, the average worker estimates they'll bring in $1,628 per month in benefits, which is 30% more than current retirees say they collect.
Overestimating your benefit can throw your retirement savings strategy out of whack. To keep that from happening, it can help to understand Social Security's complex calculation and more specifically, how Social Security determines your primary insurance amount, or the amount of money you can draw from Social Security at your full retirement age.
Let's clear up the confusion
Social Security is designed to replace 40% of workers pre-retirement income in retirement. However, the way that Social Security is calculated means that the amount you actually receive in retirement may be much higher or lower than that percentage.
A pay-as-you-go program, Social Security payments are financed by payroll taxes on current workers, but not all of a worker's income is subject to these taxes. In 2018, payroll taxes only apply on income up to $128,400. Because there's a cap on taxes, there's also a cap on the amount you can receive in benefits.
The amount of money you make every year that's subject to taxes is important, because Social Security ultimately determines how much you'll receive in benefits based on the average inflation-adjusted income you earned during your 35-highest earning years of work.
Specifically, Social Security begins its calculation by coming up with your average indexed monthly earnings (AIME).
To determine your AIME, your historical annual earnings are adjusted for inflation using Social Security's average wage index (AWI), an index that tracks national changes in wages with a two-year lag. Specifically, your historical income will be indexed based on the AWI reading for the year two years prior to the age you turn 62 -- the earliest age at which you can claim Social Security.
For instance, the historical earnings for a person turning age 62 in 2018 are indexed based on the 2016 AWI figure of $48,642.15. To adjust their historical income, Social Security divides $48,642.15 by the AWI for each year of earnings to get an indexing factor for each year. Once that's done, it multiplies each year of the person's earnings by the factor for that year to get an inflation-adjusted earnings amount. Then, it sorts out and sums up the highest 35 years of income and divides that number by 420, or the number of months in 35 years, to come up with your AIME.
What is a primary insurance amount?
Your AIME isn't the amount you'll get in Social Security benefits every month, though. To come up with that number, Social Security has to calculate your primary insurance amount.
In this step of the calculation, Social Security applies something called "bend points" at specific thresholds of your AIME to reduce the amount of your actual benefit.
The thresholds are adjusted annually by changes to the AWI, but the percentage reduction that's applied at each threshold is fixed.
FIXED PERCENTAGES OF INCOME USED IN BEND POINTS CALCULATION
Up to first bend point
Between First and Second Bend Point
Above Second Bend Point
In 2018, the first bend point applies to income up to $895, the second bend point applies to income between $895 tot $5,397, and the third bend point applies to income above $5,397.
For example, applying bend point to a person with an AIME of $5,500 would result in a primary insurance amount of $2,262, which works out to 41% of AIME. The formula for that calculation looks like this:
.9(895) + .32(5397-895) + .15(103) = $2,262
For perspective, let's look at how this calculation would impact a lower income earner and a higher income earner.
If your AIME was $1,800, then your primary insurance amount would be $1,095, or 61% of your AIME:
.9(895)+ 0.32(905) = $1,095
Now, let's say your AIME was $7,500. In that case, your primary insurance amount would be $2,562, or 34% of your AIME:
0.9(895) + 0.32(5397-895) + .15(2103) = $2,562
Finally, if you qualify for the maximum AIME of $9,936 in 2018, then your primary insurance amount would only be 29.5% of your AIME.
When you claim impacts benefits
The primary insurance amount isn't necessarily the amount you'll collect every month, either. That's going to depend on the age at which you begin collecting Social Security.
You can claim Social Security as early as age 62, but you'll only get your primary insurance amount if you wait to claim until your full retirement age, which varies between age 66 to 67 based on your birth year for people born after 1954. If you claim sooner than full retirement age, then you'll be penalized with a lower payout because Social Security is designed to pay the same amount out over your lifetime regardless of the age you claim.
For instance, if you were born in or after 1960, your full retirement age is 67. If you begin drawing Social Security at age 62, you'll collect 30% less than your primary insurance amount.
Alternatively, you can get a bonus of up to 8% per year up to age 70 if you delay taking your benefits beyond full retirement age. If your full retirement age is 67 and you begin drawing benefits at age 70, then you'd collect 24% more than your primary insurance amount.
Things to remember
The calculation is complex, but Social Security does all the heavy lifting for you. You can call Social Security or set up online access on their website to see your actual primary insurance amount and the impact of claiming at different ages. So, don't let the formula concern you.
What's important is understanding that you have some control over how big or small your primary insurance amount will be. If you're an employee, the best way to maximize your primary insurance amount (beyond asking for a raise) is to continue working. If you have fewer than 35 years of work history, Social Security uses zeroes when calculating your AIME, and that reduces your primary insurance amount. Therefore, getting rid of zeroes in your calculation can give you a big boost.
Overall, knowing how Social Security determines your benefit allows you to make smart decisions about your retirement savings plans. If you fail to plan ahead and overestimate how much you'll get in benefits, you could end up very disappointed.