In a nutshell, a Social Security retirement benefit is a percentage of your average monthly income using your highest 35 years of inflation-adjusted earnings.
So, what’s this 40-year base all about? Well, when you file for retirement benefits, the Social Security Administration will look at your earnings history and pull out your highest 40 years. They don’t have to be consecutive. But from that 40-year base, they drop out your five lowest years. So they end up using your highest 35 years of earnings to figure your benefit. If you don’t have 35 years of earnings, the SSA must plug in an annual salary of $0 for every year you did not work, until the 35-year base is reached.
However, before they add up those “high 35,” they index each year of past earnings for inflation. And this is where the formula starts to get messy. That’s because there is a different adjustment factor for each year of earnings, and each year’s adjustment factor is different based on your year of birth.
Here is a quick example. If you were born in 1962 and earned $20,000 in 1991, they would multiply those earnings by an inflation adjustment factor of 2.9, meaning they would actually use $58,000 as your 1991 earnings. But if you were born in 1960 and earned that same $20,000 in 1991, they would use an inflation factor of 2.5, resulting in $50,000 as the 1991 earnings used in your Social Security computation.
You can find a complete breakdown of those inflation adjustment factors for each year of birth at the Social Security Administration’s website: SocialSecurity.gov. If you have a hard time negotiating that website, just Google “Social Security indexing factors” and it will lead you to the right place.
The next step in the retirement computation formula is to add up your highest 35 years of inflation-adjusted earnings. Then you divide by 420—that’s the number of months in 35 years—to get your average inflation-adjusted monthly income.
The final step brings us to the “social” part of Social Security. The percentage of your average monthly income that comes back to you in the form of a Social Security benefit depends on your income. In a nutshell, the lower your average wage, the higher percentage rate of return you get. Once again, the actual formula is messy and varies depending on your year of birth. As an example, here is the formula for someone born in 1960. You take the first $1,024 of average monthly income and multiply it by 90 percent. You take the next $5,148 of your average monthly income and multiply that by 32 percent. And you take any remainder and multiply it by 15 percent.
You can find a complete breakdown of those computation “bend points” at SocialSecurity.gov. Or just Google “Social Security bend points” to find several sites that should help you.
Believe it or not, that was the simple explanation for those who just want some kind of idea of how their Social Security retirement benefit will be figured. To summarize, it is a percentage of your average monthly income using your highest 35 years of inflation-adjusted earnings. If this was a college course, you could think of it as Social Security Benefit Computation 101.
But now I’m going to get into a more advanced version of retirement benefit calculations for those who want to know the nitty-gritty of the process.
I'll start by introducing this term: the “primary insurance amount,” or PIA. The PIA is your basic retirement benefit upon which all future calculations will be based. The “raw PIA” is actually calculated at age 62. In other words, when the SSA pulls out your highest 35 years of earnings, they only use earnings up to age 62. Then that raw PIA gets “cooked,” or increased, to take into account any earnings you had after age 62 and to include any cost-of-living adjustments (COLA) that were authorized for Social Security benefits after the year you reached age 62.
But it gets a little tricky when SSA does the recomputation for any earnings you have after age 62. If you worked full time until age 67, for example, you would assume that those earnings between age 62 and 67 would increase your PIA. After all, you figure, they are some of your highest-earning years, so they will become part of that “high 35.”
But not necessarily. For reasons I can’t take the time to explain in this short column, earnings after age 60 are not indexed for inflation. They get calculated at current dollar value only. So, if your “raw PIA” was based on a full 35-year history of high inflation-adjusted earnings, your current earnings may not be high enough to become part of your “high 35,” so they won’t increase your benefit. Or they might bump up the PIA, but not by much.
In fact, I hear from readers all the time who tell me that they are confused because the benefit estimate they are getting from the SSA now (at age 67, let’s say) is not much more than the estimate they got at age 62. Their current benefit estimate includes the COLA increases but either little or no bump for their post-62 earnings. The reason is that lack of inflation indexing after age 60.
As you can see, the Social Security retirement benefit formula is pretty messy. But for most of you, I would say, don’t worry about it. Just let the SSA do it for you. Go to SocialSecurity.gov, and click on the “Plan for Retirement” icon on the homepage. It will walk you through the process of finding out what your Social Security benefit will be.
