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Financial Life Advisor
The Basics of Social Security - Understanding and Maximizing Social Security Benefits part 1 of 3
How did we get Social Security?
The idea behind Social Security is based upon a movement from welfare assistance to social insurance. Workers contribute to the risk pool through payroll taxes, and insurance is purchased to protect income. This includes disability and living too long (and not being able to work). Social Security was first created in 1935, in the wake of the Great Depression. The traditional extended family was evolving into the smaller nuclear families which we see today in modern industrialized society. The need to protect workers from being destitute was the driving force behind Social Security, and the economic realities of the Great Depression made the program politically palatable.
Social Security was not designed to be a retirement/pension system. It was designed as insurance to protect people from an inability to work because of old age or disability. Over time, the life expectancies of Americans have increased, and the entitlement of “earning” Social Security benefits has morphed the perception of what Social Security was designed to do.
A pension system collects money annually to save for a future benefit. Those funds, in turn, are invested to grow. By the time eligibility for a pension comes around, the annual contributions and investment returns have built up a significant investment value. If no new workers enter the pension system, the investments of the pension should be sufficient to pay benefits to eligible annuitants for the rest of their lives.
In Social Security, “insurance premiums” are withheld from payrolls and then most of that money goes right back out to retirees. The small surplus which currently exists is held in a trust fund that has basically loaned its full value to the Federal Government with the promise of paying those Social Security benefits in the future. The downside to this is that additional tax revenue (above FICA taxes) will be needed to pay the trust fund back. In addition, the trust fund value only covers a fraction of the future liabilities of Social Security.
Over time, life expectancies have increased and so has the cost of paying Social Security benefits. When first enacted, the total payroll tax of the Social Security system was only 1% of payroll. In 1990, the combined employer/employee OASDI tax rate reached the current level of 12.4%. Under current projections, the Social Security system will run annual deficits in 2016, and the trust fund will be exhausted in 2037.
Regardless of the reasons for starting Social Security over 70 years ago, the current system has evolved into an expected benefit which workers rely upon for their retirement plans. It would be very dangerous for any politician to cut Social Security benefits for current retirees and yet still very difficult to lower benefits for future retirees. In this series, we will explore how Social Security retirement benefits are calculated and possible ways to maximize those benefits available.
How Social Security is Calculated
Once vested, Social Security benefits are paid to workers and their families when they reach retirement age or sooner if the worker becomes disabled. There is no account balance reported to participants. The earnings history for each worker which Social Security taxes were paid is shown on Social Security Statements. This earnings record is the basis for all Social Security benefits and it is important that the earnings record is accurate.
To be vested for Social Security retirement benefits, a worker must have 40 quarters (10 years) of Social Security covered employment. Once vested, Social Security inflates the past income numbers into current equivalent salaries. This is done for each year of Social Security covered employment. Social Security then averages the top 35 years of inflation adjusted earnings and comes up with an Average Indexed Monthly Earnings (AIME). The AIME roughly equals your lifetime average gross monthly income.
Social Security then uses the AIME to calculate the Primary Insurance Amount (PIA). To do this, the AIME is applied to a regressive formula which calculates a lower percentage of AIME earnings as AIME rises. The AIME is segmented into three different levels (sometimes called “bend points”). The first level is $761 (2010). The PIA multiplies this first level by 90%. So, the PIA amount for the first $761 of AIME is $684. The next level is multiplied by 32% and the anything above that is calculated by 15%. You can see the 2010 PIA formula below.
2010 PIA Formula Using AIME
90% of the first $761 or $684
32% on the next $3,825 or $1224
15% on the next $4,134 or $647
Max PIA in 2010 = $2,556
Early, Normal or Late Retirement?
The PIA represents the monthly Social Security retirement benefits for a worker at their Normal (or Full) Retirement Age (NRA). The NRA is between 65 and 67, depending on the year of birth. Most baby boomers have an NRA 66, and gen X/Y have an NRA of 67. There is a discounting from the PIA amount for early retirement and an increasing multiplier for later retirement benefits.
Again, like the NRA, the size of the multiplier for early and late retirement is dependent on the worker’s year of birth. Baby boomers and younger get an eight percent increase for each year of delayed retirement beyond NRA. At age 70, that increase reaches the maximum of 132 percent of the NRA benefit. The maximum reduction for early retirement is for workers born after 1960. That reduction is a 30% discount of the PIA amount (or NRA benefit). The maximum monthly benefit for a worker retiring at 62 in 2010 is $1,917. The maximum possible monthly benefit for a worker retiring at 70 in 2010 is $3,361.
There are many factors to consider when deciding when to take Social Security benefits. For instance, the taxation of benefits can vary depending on when benefits are taken, and benefits each worker may be eligible to receive based on their spouses record can be affected by when they begin to receive benefits.
Spousal & Widow Benefits
For married couples (and some divorced spouses), it is possible to receive spousal retirement or widow(er) benefits. Each married worker has eligibility for spousal retirement benefits based upon their partner’s work record. The spousal benefit is one half of the worker’s benefit at NRA. So if a spouse has a PIA of $2,000 at NRA, their spouse would be eligible for a spousal retirement benefit of $1,000 at the spouse’s NRA. Like a worker who can file for benefits early or late, it is possible to collect spousal benefits prior to NRA and also delay receiving benefits until age 70. Like worker retirement benefits, taking spousal benefits early or delaying them can increase and decrease the monthly benefit amount.
Many spouses work themselves and have earned a retirement benefits from their own work record. If this is the case, they will in effect collect the greater of the two. So, going back to the example above, the husband earned a PIA of $2,000 and the wife earned a PIA of $900. The husband qualifies for a monthly benefit at NRA of $2,000 or a spousal benefit of $450. Because the husband’s own work record entitles him to a higher benefit than his spousal benefit, he will only receive his own benefit. The wife qualifies for a retirement benefit at her NRA of $900 and spousal benefit of $1,000. In her case, she would receive $900 monthly at her NRA for her own record and $100 for spousal benefits. Her gross benefit is the same as her spousal benefit, but it is mostly “funded” by her own record.
When one spouse dies, the surviving spouse is entitled to the greater of their own benefit or their spouses. So in the example above, the surviving spouse would get $2,000 a month assuming the husband filed at his NRA. If he retires early or delay’s filing, his higher or lower benefit is passed to the surviving spouse.
The rules and calculations behind spousal and widow(er) benefits are a major area for financial planning. The question of whether and how to take Social Security benefits will be the major topic of conversation in the next segment of this series. Read more about when to file for Social Security benefits in the part 2 of this series, “When to File - Understanding and Maximizing Social Security Benefits”.
Posted by Ben Gurwitz on 9th February, 2010 | Comments | Trackbacks
Tags: Financial Planning, Social Security, Retirement Planning, Feb 10
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