Social Security is
probably the most popular federal program, yet most people
know almost nothing about it. In practice, Social Security's
complex benefit formulas and rules make it difficult for
people to understand how their retirement benefits will
work.
This paper explains what
Social Security is and how it works. The first section explains
what Social Security is and which programs are and are not part of
Social Security. The second section explains the payroll taxes that
mainly finance Social Security and how they are paid. The third
section explains what Social Security's trust funds are and are
not. The fourth and longest section discusses how Social Security
benefits are calculated and who is eligible to receive them. A
companion paper will discuss the fiscal problems facing the current
system and why changes are necessary. All of the information
contained in this paper comes from Social Security
Administration (SSA) sources.
What
Is Social Security?
Social Security is the
most popular government program and touches the life of every
worker in America, but most people know little or nothing about how
it operates. The following discussion explains what Social Security
is and how it operates.
Social Security's Major
Programs.
While most discussions
focus only on Social Security's retirement program, Social Security
actually consists of three major programs, all of which are
administered by the Social Security Administration.
Specifically:
Retirement.Social Security's retirement program
provides a lifetime monthly income for qualified workers once they
reach their full retirement age. Depending on when they were born,
that age ranges from 65 to 67. The amount of retirement
benefits that a worker receives depends on his or her income while
working. Workers also have the option of receiving a lower monthly
income starting at age 62.
Survivors. Social Security's survivors program
provides a monthly lifetime income to the surviving spouse of
a deceased worker once he or she reaches retirement age. The amount
of the monthly benefit depends on both spouses' income while they
were working. The survivors program also pays benefits to
children under the age of 18 and the surviving spouse caring for
them. Unless they are disabled, children's benefits end when
the last child either reaches age 18 or graduates from high school,
whichever is later.
Disability. Social Security also pays lifetime
monthly income to workers who are disabled and, in some cases, to
their spouses and children under the age of 18. These benefits
depend on the worker's earning history.
Qualifying for Social
Security.
Workers do not
automatically qualify for Social Security retirement benefits.
Instead, they must work and pay a minimum level of Social Security
taxes
for at least 40 quarters during their working lives. These 40
quarters do not have to be consecutive. Currently, workers
earn a credit for each three-month period in which they earn at
least $900. Once they have worked and paid Social Security
taxes
for the required 40 quarters, they are fully qualified to
receive Social Security retirement benefits. If workers have paid
Social Security
taxes
for a certain number of quarters in the
recent past,[1] they are also qualified to
receive disability benefits and to have survivors benefits
paid to their spouses and to their children who are under the age
of 18.
Disability benefits are
paid to workers who have been disabled for at least one year. In
order to qualify, a worker must have paid Social Security taxes
within the recent past. "Disabled" in this case means unable to
perform any substantial gainful work due to severe physical or
mental impairment. Determination of eligibility is based on
medical evidence and made by a government agency in the state in
which the worker lives.
There is no requirement
that an individual must be an American citizen to qualify for
Social Security. While employers are required by other laws to
ensure that anyone they hire is either a citizen or a legal
immigrant, foreign nationals can earn Social Security credits with
a valid Social Security number.
Supplemental Security
Income.
>The Supplemental
Security Income (SSI) program is not part of Social Security. Even
though the Social Security Administration administers SSI, the
program is paid for with general tax revenues. No Social
Security payroll taxes are used to pay for SSI. SSI helps
aged, blind, and disabled people who have little or no income. It
provides cash to meet basic needs for food, clothing, and shelter.
To get SSI, a worker must be blind, disabled, or at least 65 years
of age.
Medicare.
>
Medicare
is a federal
program that helps to pay for older Americans' health costs. Some
people incorrectly consider
Medicare
to be part of the Social
Security system because
taxes
that finance part of
Medicare
are
lumped in with those that pay for Social Security. However,
Medicare is also financed by premiums and general
revenue, and it is not administered by the Social Security
Administration. For these reasons, Medicare is not considered
part of Social Security.
FICA.
The
taxes
that pay for
Social Security's programs are confusing to most people. On most
workers' paychecks, the
taxes
that pay for both Social Security and
Medicare
are lumped together under the term "FICA" (Federal
Insurance Contributions Act). Even the amount under FICA is
misleading because it shows only half of the
taxes
paid on the
worker's behalf.
Payroll
Taxes and Amounts
Unlike most other
government programs, Social Security (like Medicare) is funded
through explicit taxes that are not supposed to be used for any
other purpose. These taxes are based on a worker's earned income
and deducted from his or her paychecks. For that reason,
Social Security taxes are often referred to as "payroll taxes."
These payroll taxes are in addition to any income taxes that the
worker must pay.
Separate payroll taxes
finance Social Security's retirement and survivors benefit program,
Social Security's disability benefit program, and Medicare;
yet the three are often lumped together as one line item on a
worker's pay stub. The two Social Security taxes are paid only on
income up to a certain annual amount. Medicare taxes are
collected on all earned income.
In 2005, workers and
employers will pay payroll taxes totaling 15.3 percent of the
first $90,000 of income and 2.9 percent of income above that
amount. The $90,000 dividing line is called the "earnings
limit"-sometimes referred to as the "wage cap." Of that 15.3
percent total, 10.6 percent of income pays for Social
Security's retirement and survivors program, and 1.8 percent pays
for Social Security's disability program. The remaining 2.9 percent
is used to pay for Medicare programs, but the Medicare taxes are
not subject to the earnings limit. In other words, Medicare
taxes are collected on all of a worker's earned income, not
just the first $90,000.
The worker and the
employer each pay half of the payroll taxes. The self-employed pay
both portions.
FICA Defined.
The paycheck stubs
from most employers do not show the individual amounts that the
worker pays for Social Security and Medicare. Instead, these
taxes are lumped together and shown as a deduction for
"FICA."
The Federal Insurance
Contributions Act is the part of the Internal Revenue Code that
gives the federal government the authority to collect the payroll
taxes that pay for the Social Security programs and part of
Medicare. The name implies that the taxes for these programs are
actually contributions to a social insurance system. In
reality, however, they are nothing more than taxes, and it
would be more honest to refer to them as such.
Matching Deductions by the
Employer.
In most cases, only half
of the Social Security
taxes
that a worker pays are shown on the
paycheck stub. Employers also pay an equal amount of payroll
taxes
on the worker's behalf. As far as the employer is concerned,
these additional
taxes
are part of the worker's pay. Even though
the worker never sees this income, the employer actually pays
$10,765 for each $10,000 the worker earns ($10,000 in wages and
$765 in payroll taxes). If that worker were not employed, the
employer would not be required to pay the $765 in taxes.
If this money was not paid
to the government as payroll taxes, it could go to the worker as
wages. For this reason, both halves of the FICA tax should be
counted as being paid by the worker. Thus, instead of paying taxes
equal to 5.3 percent of income for retirement and survivors
benefits, the worker is actually paying 10.6 percent of income. The
combined total is the true cost to each worker.
Self-Employed
Workers.
This reality is clearly
illustrated by self-employed workers, who must pay both the
employer and the employee halves of the payroll taxes. Combining
the payroll taxes for Social Security's retirement and survivors
program, Social Security's disability program, and
Medicare
, the
self-employed pay a total of 15.3 percent of income below $90,000
in 2005 and 2.9 percent of income above that amount. These payroll
taxes are in addition to any income taxes.
Retirement and Survivors
Tax. The
largest portion of FICA payroll taxes is used to pay for a worker's
retirement and survivors benefits. The taxes pay for both the
monthly benefits to workers who have retired and the monthly
benefits (after the worker's death) to their surviving spouses and
children (under the age of 18). The worker and employer each pay
5.3 percent for a total of 10.6 percent of income up to the
earnings limit for these programs. These taxes go into the Old-Age
and Survivors Insurance (OASI) trust fund.
Disability Tax.
taxes equal to 1.8
percent of income (up to the earnings limit) go into the
Disability Insurance (DI) trust fund and pay monthly benefits
to workers who are unable to work due to a long-term physical or
mental disability. As with all payroll taxes, half of the amount
(0.9 percent of income) is deducted from the worker's pay, and the
employer pays the other half on the worker's behalf.
The Earnings
Limit. In
2005, Social Security taxes will be collected on only the first
$90,000 that a worker earns. This figure is known as the "earnings
limit" and is adjusted each year. Social Security benefits are paid
only on the amount of income that is subject to the Social Security
payroll tax. Thus, in Social Security's eyes, both Michael Jordan
and Bill Gates earn $90,000 per year regardless of their actual
incomes, and their Social Security retirement benefits will reflect
this.
The earnings limit
protects Social Security from having to pay benefits on Bill
Gates's entire income. It allows the program to say that it
covers all Americans without paying the very rich benefits
that are much higher than those that go to average-income workers.
Every October, Social Security calculates and announces the
earnings limit for the following calendar year, based on the growth
of wages in the economy. Wage growth is slightly higher than the
rate of inflation (growth of prices).
Developed as part of the
1983 Social Security reforms, this formula for increasing the
amount of wages that are taxed for Social Security was
supposed to cover 90 percent of the nation's total wages.
However, this proportion has gradually declined and is now closer
to 85 percent.
Income taxes on Some
Social Security Benefits.
Since 1983, retirees with
annual income above a certain amount have been required to pay
income
taxes
on a portion of their Social Security benefits. The
money raised through this tax is returned to either Social Security
or Medicare.
Retirees who earn between
$25,000 and $34,000 and file as individuals may have to pay income
taxes on up to 50 percent of their benefits. If they earn more than
$34,000, they may have to pay income taxes on up to 85 percent of
their benefits. Married retirees who earn between $32,000 and
$44,000 may have to pay income taxes on up to 50 percent of their
benefits, and if they earn over $44,000, up to 85 percent of their
benefits may be taxable. These income thresholds are not indexed
for inflation. Income tax on social security benefits are
paid at the same rates as on other types of earned
income.
Until 1983, all Social
Security benefits were income tax free. In that year, Congress
decided to tax 50 percent of the Social Security benefits of
workers with total retirement incomes over $25,000 (for single
retirees) because Social Security needed additional revenue.
Congress justified the move by pointing out that the half of
payroll taxes paid by employers can also be deducted from the
employer's corporate income taxes, while workers must pay income
taxes on the amount of their check that is deducted as payroll
taxes. Congress decided that since companies received a tax
deduction on the amount of payroll taxes paid on behalf of their
workers, Congress could recapture that tax benefit by assessing
income taxes on half of some retirees' benefits.
In 1993, problems with
financing Medicare led Congress to raise the proportion of Social
Security benefits that is subject to income taxes to 85
percent for workers with incomes over $34,000 (for single
retirees). The money raised from this tax goes to the Health
Insurance trust fund.
The
Social Security Trust Funds
Many people tend to think
of their Social Security benefits as coming from an actual
account, in their name, which contains cash or investments. People
who believe this often point to the existence of the Social
Security trust funds to justify their belief. However, this belief
is fallacious for two reasons. First, Social Security has no
individual accounts at all, other than a bookkeeping record of
an individual's yearly earnings and payroll taxes. Second, the
program's trust funds do not contain cash or saleable assets. They
only represent the amount of Social Security taxes collected
beyond what the program needs to pay current benefits.
In reality, the Social
Security trust funds contain nothing more than IOUs that have no
value beyond a promise to impose higher taxes on future workers.
The annual surpluses that many thought were being used to build up
a reserve for baby boomers have been spent to fund other
government programs or to reduce the government
debt.
The OASI and DI Trust
Funds.Social Security has two
trust funds: the Old-Age and Survivors Insurance trust fund and the
Disability Insurance trust fund. These two trust funds are linked
and are often referred to as a single trust fund, the Old-Age,
Survivors, and Disability Insurance trust fund, or
OASDI.
Despite the fact that
there are two trust funds, most of the estimates of Social
Security's finances use the combined OASDI trust fund, which is an
important distinction. For instance, according to the 2004 trustees
report, OASDI will begin to spend more than it takes in by 2018.
Considered separately, the OASI trust fund is also predicted to
begin to spend more than it takes in each year starting in 2018,
but the DI trust fund will begin to spend more than it takes in
starting in 2009.
In addition to the two
Social Security trust funds, there is a Health Insurance (HI) trust
fund that partially funds Medicare. The HI trust fund is managed
and invested in the same way as the OASI and DI trust funds but is
outside the scope of this paper.
The Trustees and Their
Annual Report.The same trustees manage
the OASI, DI, and HI trust funds. Three of the six trustees are
Cabinet officials: the Secretary of the Treasury, Secretary of
Labor, and Secretary of Health and Human Services. The
Secretary of the Treasury serves as the managing trustee. In
addition, the Commissioner of Social Security is a trustee, and two
public trustees are appointed by the President and confirmed by the
Senate for four-year terms. The terms of public trustees John L.
Palmer and Thomas R. Saving expired in October 2004, but they can
continue in their roles until the 2005 trustees report is
released.
Every year, the trustees
are required to issue a report that details both the financial
activities in the trust funds and the long-term and short-term
outlooks for Social Security's programs. Available from SSA both
on-line and in published copies, these annual reports contain a
wealth of numbers, statistics, and predictions. In addition to the
numbers from the most recent year, the reports predict Social
Security's financial status for both the next 10 years and the next
75 years.
Recently, the trustees
have also developed a perpetual measure that extends well beyond
the 75-year measure. This is intended to respond to critics who
fail to understand that any reform that is based on the 75-year
measure alone could leave the system on a path that would result in
huge new deficits just one year beyond that 75-year
horizon.
The report includes
predictions based on the most likely economic scenario as well as
both more optimistic and more pessimistic outcomes. Some analysts
make the mistake of assuming that the three outcomes are equally
likely to happen. However, a deeper analysis shows that there is
only an extremely small chance that either the optimistic or the
pessimistic outcome will happen, while there is a very high chance
that the most likely outcome will occur. For that reason, the most
recent trustees reports include a stochastic analysis that shows
the probabilities of each outcome's actually
happening.
Often, press reports focus
on the simplest statistics, such as the year in which the
trust funds are predicted to run out of assets. However, a more
careful examination reveals other important information, such
as the amount that Social Security owes in promised benefits beyond
what it can pay with payroll taxes. The report also indicates the
year in which the programs must begin to spend more than they
receive in payroll taxes. These are actually more important to
determining the programs' ability to meet the needs of those
who depend on them.
The OASI Trust
Fund. The
Old-Age and Survivors Insurance trust fund-by far the larger
of the two Social Security trust funds-pays retirement and
survivors benefits. In 2003, the OASI trust fund had a total income
of $543.8 billion. Of that total, $456.1 billion (83.9 percent)
came from payroll taxes; $12.5 billion (2.3 percent) came from
income taxes paid on higher-income retirees' Social Security
benefits; and $75.2 billion (13.8 percent) came from interest paid
on special-issue Treasury bonds in the trust fund.
During 2003, the trust
fund paid out $399.8 billion in benefits (73.5 percent of tax
receipts) and $2.6 billion (0.5 percent) for administrative
expenses. The remaining $137.8 billion (25.3 percent) was
retained in the trust fund. As a result, the trust fund's assets
grew from $1.217 trillion at the beginning of the year to $1.355
trillion at the end of 2003.[2]
The Disability Insurance
Trust Fund.The Disability Insurance
trust fund-the smaller of the two Social Security trust funds-pays
disability benefits. In 2003, the DI trust fund had a total income
of $88.1 billion. Of that total, $77.4 billion (87.9 percent)
came from payroll taxes; $0.9 billion (1.0 percent) came from
income taxes paid on higher-income workers' disability benefits;
and $9.7 billion (11.0 percent) came from interest paid on
special-issue Treasury bonds in the trust fund.
During 2003, the trust
fund paid out $70.9 billion (80.5 percent of tax receipts) in
benefits and $2.0 billion (2.3 percent) for administrative
expenses. The remaining $15.0 billion (17.0 percent) was retained
in the trust fund. As a result, the trust fund's assets grew from
$160.4 billion at the beginning of the year to $175.4 billion at
the end of 2003.[3]
The disability program's
separate trust fund and tax structure, combined with the completely
different eligibility criteria for receiving disability
benefits, distinguish it from the retirement and survivors program.
The disability program is a true insurance program, while the
retirement and survivors program is much closer to a
retirement investment program.
How the Social Security
Trust Funds Differ from Real Trust Funds.Private-sector trust funds
invest in real assets, ranging from stocks and bonds to mortgages
and other financial instruments. Assets are held only for a
specific purpose, and the fund managers are liable if the money is
mismanaged. Funds are managed in order to maximize earning
within a pre-agreed risk level. Investments are chosen to provide
cash at set intervals so that the trust fund can pay its
obligations.
The Social Security trust
funds are very different. As explained by the Office of
Management and Budget (OMB):
The Federal budget meaning
of the term "trust" differs significantly from the private sector
usage…. [T]he Federal Government owns the assets and
earnings of most Federal trust funds, and it can unilaterally raise
or lower future trust fund collections and payments, or change the
purpose for which the collections are used.[4]
Even more important, the
Social Security trust funds are "invested" only in a special type
of Treasury bond that can only be issued to and redeemed by
the Social Security Administration. These bonds cannot be sold to
the public to raise money. They are only a measure of what the
government owes itself. As the Congressional Research Service
noted:
When the government issues
a bond to one of its own accounts, it hasn't purchased anything or
established a claim against another entity or person. It is simply
creating a form of IOU from one of its accounts to another.[5]
As a result:
These [Trust Fund]
balances are available to finance future benefit payments and other
trust fund expenditures-but only in a bookkeeping sense. These
funds are not set up to be pension funds, like the funds of private
pension plans. They do not consist of real economic assets that can
be drawn down in the future to fund benefits. Instead, they are
claims on the Treasury, that, when redeemed, will have to be
financed by raising taxes, borrowing from the public, or reducing
benefits or other expenditures. The existence of large trust fund
balances, therefore, does not, by itself, make it easier for the
government to pay benefits.[6]
In short, the Social
Security trust funds are really only an accounting mechanism. They
show how much the government has borrowed from Social Security but
do not provide any way to finance future benefits.
How Money Goes to and from
the Trust Fund.An employer pays taxes to
the Treasury by periodically sending a check (or electronic
transfer) that includes both income taxes and payroll taxes. The
check is sent without distinguishing between payroll and income
taxes. There is also no indication of which individual
employees' taxes are being paid or how much those employees
earned.
On a regular basis, the
Treasury estimates how much of its aggregate tax collections are
due to Social Security taxes and credits the trust funds with that
amount. No money actually changes hands: This is strictly an
accounting transaction. These estimates are corrected after income
tax returns show how much in payroll taxes was actually paid
in a specific year. In addition, the Treasury credits the
trust funds with interest paid on its balances and with the amount
of income taxes that higher-income workers pay on their Social
Security benefits.
To pay benefits, the
Social Security Administration directs the Treasury to pay
monthly benefits, and that amount is subtracted from the total in
the trust funds. Any remainder is converted into special-issue
Treasury bonds, which are really nothing more than IOUs.
After the trust fund has
been credited with the IOUs, Social Security's extra tax revenue is
then spent by the Treasury just as any other taxes are spent. If
the federal budget is running a surplus, that amount could be used
to repay federal Debt owned by the public. Otherwise, it is spent
on any other type of federal program, ranging from aircraft
carriers to education research.
Special Securities Issued
to the Trust Funds.
>The Social Security trust
fund consists only of special-issue
Treasury
bonds. These
bonds are special in that they can only be issued to and redeemed
by the Social Security trust funds. They cannot be sold in the open
market.
The Social Security trust
fund bonds pay the same interest rate as regular Treasury bonds
issued on the same day with the same maturity date. When the bonds
mature, they are rolled over into new bonds that include both the
original issue amount and any interest due. The new bonds also pay
the same interest rate as comparable Treasury bonds.
Because these are
special-issue bonds that are payable only to the Social Security
Administration, the SSA cannot sell them to a third party to raise
money to pay benefits. This reinforces the fact that these bonds
are really nothing more than IOUs from one branch of government to
another. They are not a real financial asset.
Until relatively recently,
these bonds existed only as entries in a record book. Now, however,
when a new bond is issued, it is printed on a laser printer located
at the Bureau of the Public Debt office in Parkersburg, West
Virginia. The bond is then carried across the room and put in a
fireproof filing cabinet. That filing cabinet is the Social
Security trust funds.
How Trust Fund IOUs Would
Be Repaid.
At some point in the
future, probably starting about 2018, Social Security will start to
pay more in benefits than it receives from payroll taxes. At that
point, it will begin to cash in the bonds in the trust fund.
According to the most recent trustees report, Social Security will
cash about $5.7 trillion (in 2004 dollars) in special-issue bonds,
cashing the first special-issue bond in 2018 and the last bond in
2042.
According to the OMB,
there are only four ways that Congress can repay these bonds: raise
other taxes, authorize the Treasury to borrow the needed funds from
the public, reduce spending on other federal programs and use the
savings to redeem Social Security's bonds, or simply reduce Social
Security benefits. None of these options is easy or
attractive.
Determining
Social Security Benefits
Social Security benefits
are based on earnings averaged over most of a worker's lifetime.
Most people know about Social Security's retirement benefits, but
the program also pays benefits to disabled workers. In
addition, families can receive benefits under certain
circumstances. The formula that the agency uses to determine the
benefits for a worker or the worker's Family is complex.
Complicating matters even more are a number of special
circumstances that can alter those benefits.
What follows is a general
analysis that is suitable for policymakers. For individual
cases, it would be wiser to seek guidance from either the SSA or
other sources.
When Can a Worker
Retire?
There are two answers to
this question. A worker can begin to collect Social Security
retirement benefits as early as age 62 but cannot begin to receive
full retirement benefits until between ages 65 and 67. The
exact age for full benefits depends on the worker's birth date.
Workers born before 1938 can receive full retirement benefits
starting at age 65. The full retirement age increases by two months
per year for workers born between 1938 and 1942 and is 66 for those
born between 1943 and 1954. The full benefits age then increases by
two months per year for those born between 1955 and 1959 and is 67
for anyone born in 1960 or after.
If a worker decides to
receive benefits starting at age 62, the monthly benefits will be
reduced by a set percentage for each month that the worker receives
benefits before full retirement age. As the full retirement age
increases from 65 to 67, workers who retire early will receive
an even greater reduction in their monthly benefits. Currently, a
worker who retires at 62 will receive 80 percent of the full
retirement age amount. This will eventually drop to 70 percent
for those with a full retirement age of 67.
Even after a worker
reaches full retirement age, the worker's benefits continue to
increase every month until that worker applies to receive
retirement benefits. This benefit growth continues until age
70.
Qualifying for Retirement
Benefits.
Not everyone is
qualified to receive Social Security benefits. To qualify, a worker
must earn at least 40 quarterly credits. A worker earns one credit
by earning at least $900 in a three-month period and paying Social
Security
taxes
on that amount. Workers who earn $3,600 during a
year earn four credits.
The amount of income
required to earn a credit is adjusted annually, but this does not
affect credits that have already been earned. Once a worker has
earned the required 40 credits, he or she is permanently
qualified. However, the level of benefits depends on worker's
income history.
The Disability Insurance
program has similar requirements, but the number of credits
necessary to qualify varies depending on the age at which the
worker becomes disabled. In general, the younger the person who is
disabled, the lower the number of credits required to qualify for
benefits.
The General Formula for
Retirement Benefits.
Retirement benefits are
based on a worker's highest 35 years of earnings. Those wages are
indexed so that all 35 have the purchasing power of the year when
the person retires. The worker's Average Indexed Monthly Earnings
(AIME), or average monthly salary, is calculated using the 35 years
of indexed earnings. The AIME is then run through a formula that
calculates benefits equal to 90 percent of AIME up to a certain
level of monthly income, 32 percent of AIME from that level to a
higher point, and 15 percent of the remaining AIME.
The dividing points
between the three payment levels are known as "bend points." The
three payment levels are added up to find the worker's monthly
Social Security retirement benefit. Both steps are detailed
below.
Determining Average
Indexed Monthly Earnings (AIME).
Retirement benefits are
calculated using a worker's highest 35 years earnings. They do not
have to be consecutive years. If the worker has an earnings record
for more than 35 years, only the 35 years of highest earnings are
included in the calculation; years with lower earnings are dropped.
Only those earnings on which the worker paid Social Security
taxes
are counted. Thus, if the worker earned $100,000 in 2004, that
year's income would be counted as $87,900 for determining benefits,
since the worker only paid Social Security
taxes
on the lower
amount.
Except for the two years
immediately prior to retirement, earnings for previous years are
indexed so that all years are measured by the same ability to
purchase goods and services; the two years immediately before
retirement are not indexed. This indexing increases past earnings
to account for both inflation and increases in average wage growth.
For instance, it would take $12.05 in 2004 dollars to equal $1.00
earned in 1951, and $1.61 to equal $1.00 earned in 1990.
Once the 35 years of
highest earnings are determined, they are totaled and divided
by 420 (the number of months in 35 years). The result is the
Average Indexed Monthly Earnings, which is used to calculate Social
Security benefits.
Some jobs-usually for
state or local governments-are not covered by Social Security,
and earnings for those jobs are not included in calculated
AIME. For the purposes of determining Social Security benefits,
those years count the same as if the worker was not
employed.
If a worker did not work
for a full 35 years- perhaps due to raising a Family or because of
illness-the missing years are counted as zeros. For example,
if a worker is either employed for only 25 years or worked in a job
covered by Social Security for only 25 years, the indexed earnings
from those 25 years are added together and divided by 420. This
lowers that worker's AIME to account for the missing years. Social
Security benefits earned by state and local government workers
are adjusted in other ways, as explained in the sections on
the Government Pension Offset and the Windfall Elimination
Provision.
Wage Indexing vs. Price
Indexing.
>In creating AIME, a
worker's past wages are indexed to bring them to the same level as
today's earnings. There are two general ways to index past earnings
and potentially dozens of variations on these two that would create
results that lie in between the two general methods. This
calculation is done only once in a worker's life-when he or she
first applies for Social Security benefits. Once the worker's
initial monthly benefit has been determined, it is price
indexed in each successive year to protect the retiree from
inflation.
Price indexing is based
upon the Consumer Price Index (CPI) and compensates for inflation.
Price indexing benefits ensures that they maintain their constant
purchasing power. In this case, if inflation had increased by 5
percent since last year, simply multiplying the previous year's
benefit by 1.05 would preserve the retiree's ability to buy the
same amount of goods as last year.
By contrast, wage indexing
is based on the growth in average wages in the economy over a set
period of time and is supposed to allow workers to retire with
the same standard of living. The growth in average wages includes
both inflation and growth in the overall economy. As a result, wage
indexing almost always results in a higher AIME than price
indexing. Social Security uses wage indexing only when calculating
AIME, determining the annual level of bend points in the benefit
level, and determining the annual level of the payroll tax earnings
cap.
The difference between the
two forms of indexing can be important. If a worker had been a
bricklayer throughout his or her career and earned $4.00 per
hour in 1980, indexing that amount for inflation (an increase
of 129.3 percent) would result in an indexed wage of $9.17 per
hour.[7] On the other hand, indexing for
average growth in wages (an increase of 172 percent) would result
in $10.88 per hour.[8] While it is true that $9.17 in
2004 would buy the same amount as $4.00 in 1980, the average wage
for a bricklayer could have increased to something closer to
$10.88 per hour in 2002.
Wage indexing allows
retirees to take advantage of the increase in the standard of
living over their working careers. However, it is often criticized
as giving workers a retroactive credit for improvements in the
economy. In other words, the worker's 1980 wages are being measured
according to the economy of 2004 rather than according to the
1980 economy in which they were earned.
The key difference is in
replacement rates. The replacement rate is the proportion of a
worker's average monthly earnings that is paid by that worker's
Social Security retirement benefit. Currently, Social Security
pays average-income workers a retirement benefit that is equal
to between 40 percent and 45 percent of their average monthly
earnings. Lower-income workers generally receive a higher
proportion of their average monthly earnings, while higher-income
workers receive a lower proportion.
With wage indexing, these
replacement rates will remain roughly stable. On the other hand,
changing to price indexing will gradually reduce the replacement
rates. While this would bring promised Social Security benefits
closer to what the program can afford to pay, it would also require
workers to make up the difference from either savings or some other
form of retirement plan. Most experts believe that a retiree needs
an income equal to roughly 70 percent of pre-retirement income
for a comfortable retirement.
Annual COLA
Increases.
>Once a worker's monthly
benefits have been determined, they are increased every year by the
rate of inflation. This Cost of Living Adjustment (COLA), is
intended to preserve the purchasing power of a recipient's
benefits. The amount of the annual increase is announced each
October and takes effect the following January.
The COLA is based on the
inflation rate for the preceding 12 months from October 1 to
September 30. For example, in October 2004, the SSA announced
a COLA increase of 2.7 percent for all checks issued after January
1, 2005. This increase was based on the change in CPI-W from
October 1, 2003, through September 30, 2004.
The SSA currently uses the
Department of Labor's Consumer Price Index for Urban Wage Earners
and Clerical Workers (CPI-W) to measure inflation, but the law
allows it to substitute other inflation indexes or the annual
increase in average wages under some circumstances.
Using Bend Points to
Calculate the Monthly Benefit.
Once an AIME has been
determined, the SSA calculates a worker's monthly retirement
benefit using a formula that pays a higher benefit
relative to income to lower-income workers than to
higher-income workers. In 2004, Social Security paid 90 percent of
the first $612 of a worker's AIME, 32 percent of the AIME amount
between $612 and $3,689, and 15 percent of any AIME amount over
$3,689. The dividing points in this formula are called "bend
points." The SSA adjusts the bend points each year.
The bend points ensure
that a lower-income worker receives Social Security retirement
benefits that are comparatively higher relative to
pre-retirement income than upper-income workers receive. For
example, a worker with an AIME of $4,000 (or an average annual
income of $48,000) would receive 90 percent of the first $612
($550.80); 32 percent of the amount between $612 and $3,689
($984.64); and 15 percent of the amount between $3,689 and $4,000
($46.65). Thus, the worker's monthly benefit would be $1582.09, or
about 40 percent of AIME.
On the other hand, a
worker with an AIME of only $1,200 (or an average annual income of
$14,400) would receive 90 percent of the first $612 ($550.80) and
32 percent of the amount between $612 and $1,200 ($188.16), for a
total monthly benefit of $738.96. This lower monthly benefit amount
would equal 61 percent of his or her AIME.
The Spousal
Benefit.
>In addition to the
retirement benefits that a worker can receive, the worker's
spouse can also receive a benefit in some circumstances. Almost all
spouses who qualify for the full benefit come from single-earner
families in which one spouse was employed and the other stayed at
home to care for the family. The spousal benefit is equal to 50
percent of the employed spouse's benefit, which means that such
families could receive a total Social Security income of 150
percent of the working spouse's benefit while both are still
alive.
The "dual entitlement
rule" prevents spouses who qualify for their own Social Security
retirement benefits from receiving both their own
benefits and a spousal benefit. An exception is made if the
lower-earning spouse's benefits are less than 50 percent of the
higher-earning spouse's benefits. In that case, the lower-earning
spouse would also qualify for a spousal benefit equal to the
difference between his or her retirement benefits and 50
percent of the higher-earning spouse's benefits.
Some special
circumstances-for example, if one spouse was employed by a state or
local government that is not part of Social Security-can make
it appear that someone qualifies for spousal benefits even though
they may have substantial income or retirement benefits from the
non-Social Security job. The Government Pension Offset addresses
this circumstance and limits spousal benefits to families that
truly qualify for it.
Survivors
Benefits.
The amount of the
survivors benefits paid to spouses and children under the age
of 18 depends on the earnings history of the deceased worker. The
same formula that calculates retirement benefits is also used
for survivors benefits. They are usually calculated as a
percentage of the benefit for which a worker would have been
eligible at the time of death.
Surviving spouses near
retirement age receive a benefit that is based on the worker's
retirement benefit. If the worker began to receive benefits at a
full retirement benefits age, the surviving spouse will receive an
amount equal to 100 percent of the worker's benefits. This is also
true if the worker died before begining to receive Social Security.
However, if the surviving spouse is also entitled to receive
benefits, he or she will receive only the larger of the two
amounts. The survivor will not receive both the worker's benefit
and his or her own benefit.
If the deceased worker
began to receive a reduced amount of retirement benefits before
full retirement age, the surviving spouse will also receive a
reduced monthly benefit. The exact amount depends on the survivor's
age and the level of the worker's benefit. A surviving spouse can
receive benefits as young as age 60, but in that case would receive
only 71.5 percent of the worker's full retirement-age benefit. As
the full retirement age increases, this percentage will also
change.
In addition to the monthly
benefit, surviving spouses receive a one-time $255 death benefit.
This benefit is payable only to spouses or children eligible to
receive benefits.
Another
situation occurs if the worker dies leaving children under the
age of 18. In that case, both the child and the surviving spouse
are eligible to receive a benefit equal to 75 percent of the
retirement benefit for which the worker was qualified at the
time of death. Both children and the spouse continue to receive
this benefit until the last child reaches age 18 or graduates from
high school, whichever is later. Benefits are also payable up to
age 19 if the child is in high school at that date or age 22 if the
child is disabled. The total annual amount that the Family can
receive from Social Security depends on a number of factors but is
between 150 percent and 188 percent of the worker's full retirement
benefit amount. Once the last child has reached an age at which
benefits end, benefits also end for the surviving spouse until he
or she qualifies for retirement benefits.
Disability
Benefits.
Currently, disability
benefits are calculated using the same formula as the one used to
calculate retirement benefits. However, disability benefits
for a worker who is disabled before having worked 35 years are
calculated using a shorter work history so that the worker is not
penalized for not having worked as long.
Obtaining
approval for Social Security disability benefits is not easy. The
agency's definition of disability is extremely strict, and
about half of workers who apply for benefits are turned down.
Some of these applicants will be approved on appeal, but the
process can be long and complicated.
To
qualify, a worker must be unable to do any kind of substantial work
because of physical or mental disabilities, which are expected
either to last at least 12 months or to result in death. Merely
being unable to do the job that he or she held before the
disability does not automatically qualify a worker for disability
benefits. Depending on the worker's age, experience, and education,
the worker may be regarded as qualified for other work and thus be
denied disability benefits, even if the work is at a lower salary.
Family members may also be eligible to receive benefits because of
a worker's disability.
Because
the disability insurance program functions as a true insurance
program with its own tax, trust fund, and eligibility process, it
is considered to be separate from Social Security's retirement and
survivors program.
The Retirement Earnings
Limit:Working During
Retirement. Until recently, any worker
under the age of 70 who received Social Security retirement
benefits and chose to return to work would lose a substantial
portion of his or her Social Security benefits. However, Congress
eliminated this penalty for workers who have reached full
retirement age. Workers between 62 and full retirement age still
risk losing much or most of their benefits if they choose to work
after applying for retirement benefits.
In 2005,
workers under full retirement age can earn up to $12,000 without
any consequences. However, for every two dollars they earned over
that amount, their Social Security benefits were reduced by one
dollar. A higher limit applies to the year in which the worker
reaches age 65.
Rather
than equally reducing each monthly benefit, Social Security
frontloads the reduction until the amount of the reduction is
reached. Thus, if annual benefits were to be reduced by $4,500 and
the worker's monthly benefit was $1,000 per month, the worker would
not receive Social Security checks for the first four months,
and the check for May would be for only $500. Starting in June, the
worker would again receive $1,000 per month through
December.
The Government Pension
Offset.
The Government
Pension Offset affects the Social Security benefits for spouses of
workers who held
jobs
that were not covered by Social Security.
Most of these workers were either state or local government
employees or were federal employees prior to 1984. Since government
workers who were not covered by Social Security do not have an
earnings record for those
jobs
or any Social Security benefits
based on that employment, they would theoretically qualify for
a full spousal benefit, even though the spouse would not qualify if
both workers had been part of Social Security.
Thus, a
person who joined the federal government prior to 1984 would,
in theory, be able to receive both a full Civil Service Retirement
System (CSRS) pension and a Social Security spousal benefit.
To eliminate this dual benefit, Congress created the
Government Pension Offset in 1977.
Under
the Government Pension Offset, two-thirds of the CSRS pension (or
in other cases, the pension that comes from a state or local
government that does not participate in Social Security) is
treated as if it were a Social Security benefit, and the worker's
Social Security spousal benefit is reduced dollar for dollar by
this amount.
For
example, if the CSRS worker's spouse receives $1,200 per month from
Social Security, the worker would technically be eligible for a
Social Security spousal benefit of $600 (one-half of the spouse's
basic retirement benefit). However, if the worker has a $1,200 per
month CSRS pension, $800 of his or her pension (two-thirds) would
be treated as coming from Social Security. This would eliminate the
spousal benefit because two-thirds of the CSRS pension ($800) is
larger than the potential spousal benefit ($600).
As a
result of the Government Pension Offset, the CSRS worker and the
worker's spouse are treated the same as married workers who are
both covered by Social Security. The Government Pension Offset
affects about 300,000 retirees and reduces Social Security's
aggregate benefits by approximately $1 billion annually. A major
proportion of those affected by this rule are retired federal
workers, and most of the rest were employed by state and local
governments that do not participate in Social Security. The vast
majority of these workers come from eight states: Alaska,
California, Colorado, Louisiana, Maine, Massachusetts, Nevada,
and Ohio.
The Windfall Elimination
Provision.
The Windfall Elimination
Provision is similar to the Government Pension Offset, except that
it applies to the retirement benefits instead of spousal
benefits. It applies only to workers who have both a Social
Security retirement benefit and a pension from a job that was not
part of Social Security.
Under
the Windfall Elimination Provision, only 40 percent (as opposed to
the usual 90 percent) of the first $612 (the first bend point in
2004) of the AIME is counted toward the worker's monthly retirement
benefit. This in turn lowers the affected worker's total monthly
benefit. For example, the monthly benefit for a worker with an AIME
of $1,200 would be reduced from $739 to $433, and a worker with an
AIME of $4,000 would receive $1,276.09 per month instead of
$1582.09.
There
are exceptions to this provision that take into account how long
the worker was employed in a job covered by Social Security. The
longer a worker was employed in a job covered by Social Security,
the lower the benefit reduction. If the worker received
"substantial" Social Security covered earnings for 30 years or
more, there is no reduction in benefits. In the case of a worker
with that level of earnings for 21 and 29 years, the 90 percent
multiplier would be reduced to between 45 percent and 85 percent,
depending on the exact number of years worked.
The
Windfall Elimination Provision adjusts the benefit formula to
reflect retirement income from employment not covered by Social
Security. It was created because the basic Social Security benefit
formula is designed to give lower-income workers more for
their Social Security taxes than higher-income workers. If a
government worker spent 30 years in a job not covered by Social
Security and only 12 years in one that is covered, his or her
Social Security earnings record (AIME) would appear to be very low
when compared to his or her actual average income including both
jobs. This is because all of the income not covered by Social
Security would be excluded from the AIME calculation. Without
this provision, a middle-income or even upper-income worker would
receive a low-income worker's Social Security benefit.
The Dual Entitlement
Rule. A
long-standing principle of Social Security holds that a worker
cannot qualify for both full retirement benefits and full spousal
benefits. Accordingly, although a married worker theoretically
qualifies for both retirement benefits from his or her own
earnings record and a spousal benefit equal to 50 percent of the
spouse's retirement benefit, the dual entitlement rule limits the
spousal benefit.
The dual
entitlement rule reduces the spousal benefit dollar for dollar by
the amount of the retirement benefits for which a worker qualifies
under his or her own earnings record. Thus, if two spouses each
qualify for $1,200 per month from their own earnings records and
for spousal benefits of $600 per month (one-half of the basic
retirement benefit), they would still receive a total benefit of
only $2,400 ($1,200 per worker). Both spouses are ineligible for
the $600 spousal benefit because their individual retirement
benefits are greater.
On the
other hand, if one spouse received $1,200 per month and the other
received $400 per month from Social Security, the
lower-earning spouse would qualify for a $200 spousal benefit.
In this case, the $600 spousal benefit from the higher-earning
spouse would be reduced by the lower-earning spouse's benefit
($600-$400), leaving a $200 spousal benefit. The dual entitlement
rule potentially affects 96 percent of the workforce.
Notch Babies.
"Notch babies" are
certain workers who were born between 1917 and 1921. Due to a
technical error in a 1972 law, they receive slightly lower benefits
than workers born before them, although they also receive slightly
higher benefits based on their earnings record than workers
born after them. As a result, legislation has regularly been
introduced in Congress that would either raise their benefits or
provide them with a lump-sum payment.
However,
a 1994 commission found that, although they do receive slightly
lower benefits than workers born before them, notch babies receive
a fair return for their taxes. As a result, no legislation
concerning notch babies has been passed, and this situation is
unlikely to change.
Notch
babies get their name from a line graph showing average benefits by
age of birth. Because those born between 1917 and 1921 tend to
receive slightly lower benefits than those born before them, the
line has a slight notch for those years.
The problem was caused in 1972 when benefits
were first indexed for inflation. Regrettably, Congress made a
technical error in writing the law that resulted in workers
receiving a double adjustment for inflation. By the time Congress
corrected this error in 1977, some workers had already retired with
higher benefits than they should have received. Rather than
lowering their benefits, Congress decided to correct the
problem for only those who had not yet retired. In addition, rather
than just correcting the law to lower benefits to where they should
have been, Congress phased in the change over a five-year period,
affecting retirees born between 1917 to 1921.
Conclusion
Social
Security is a remarkably complex program, and few people
actually understand how it operates. In many cases, terms used by
Social Security (e.g., trust fund) have meanings that are different
from the meanings conveyed by the same terms when they are used in
the private sector. However, if the current program's impending
financial problems are to be avoided, it becomes increasingly
important for informed citizens to measure different reform options
against the existing program's actual operating structure and
practices.
David
C. John is Research Fellow in Social Security
and Financial Institutions in the Thomas A. Roe Institute for
Economic Policy Studies at The Heritage Foundation.