Perhaps the most successful government program ever, Social Security was put in place as a form of “social insurance” in order to protect against people who’d worked their entire lives ending up in poverty in their old age.
Before diving into various details about benefits, there are a few things to clear up regarding the program:
- It is NOT an investment account. You do not “own” an account with some accumulating sum of money which you get “back” later. It’s an insurance system built in the form of a tax (think of it like an insurance premium) and a benefit. And like insurance, it’s entirely possible to pay “in” and never receive a dime from it (like, say, your homeowner’s insurance — you may well never make a claim on it). That said, the vast majority of workers who pay the taxes (again, think “insurance premiums”) will, in fact, eventually collect benefits (“make a claim on that insurance”) because the event it’s insuring against is simply living long enough.
- You may read about “effective return” on the money you paid in. It’s bunk. You paid taxes. It was never an investment account and computing “returns” doesn’t make sense. Nevertheless, the fact is that early participants in the system (those who lived long enough) collected vastly more in benefits than they ever paid in taxes, but that calculus may not work for folks nowadays. That doesn’t mean it’s a bad program, a waste of money, or a bad investment. It’s not an investment. It’s an insurance program built on a tax on earned income. It makes more sense to compare it to insurance than to investments — and insurance and investments, though they may have in common the fact that you pay money and eventually may get money back — are still very different beasts.
- We are going to simplify here and address, mainly, just the OASI — Old Age and Survivors Insurance — piece. This is the standard benefits that people get when they reach “full retirement age” and their spouses may also collect “spousal benefits” out of and also “survivors benefits” for a surviving spouse. The complete collection of Social Security programs is more complex than just that part, including disability insurance, for example.
- While there has been some talk of the system going “bankrupt” — it just doesn’t work that way. Most of the current benefits paid out are paid from the taxes collected at the same time. Workers pay taxes, the government collects those taxes and turns around and uses them to pay benefits. For a while, the taxes collected were greater than the benefits being paid out. The excess has been collected into a “trust fund”. At the moment, the taxes (and other payments collected, such as interest on the existing trust fund assets) exceeds the annual payout. In the near future, the payouts will start to exceed the incoming money — at which point the system starts to run a deficit — and at which point the accumulated trust fund (currently nearly $3trillion!) will have to get spent down. The trust fund has substantial assets and is not projected to be spent down completely until 2033. Even after the trust fund is emptied out, in 2034, they expect then-collected incoming money to be sufficient to continue paying 77% of the currently promised future benefits. That’s a big problem — but it’s not the same thing as Social Security going away — it’s effectively just a “worst case scenario” — that with no changes to the system or structure, at a minimum, it’s reasonable to expect 77% of currently promised benefits, starting in 2034. And historically, the assumptions used for these projections have been fairly conservative, too.
- Your starting benefit, because it’s based on your wage history, is effectively adjusted for wage growth over time. Once you start collecting benefits, however, those benefits are adjusted yearly for inflation. Historically, wage growth has been faster than inflation.
- The timing of starting your benefits can have enormous impact on your future lifetime benefits collected. Married folks have even more complex timing issues to consider to optimize those benefits. And all such “optimized” benefits necessarily need to make assumptions about your life expectancy (and other factors). Optimizing benefits and timing is something worth reviewing with a professional who understands these issues (and, likely, also has software to help model and project these things out.)
- If you’re divorced, but were married for more than 10 years to a spouse who has earned benefits, you may be entitled to spousal benefits based on that spouse’s earnings history even though you’re no longer married. This, too, can be tricky (because you may not actually know what those benefits are until you actually apply for them!).
How are Social Security Benefits computed?
Basically, as long as you have earned income, you pay Social Security taxes (usually indicated on your paystub as “OASDI”). The current rate is 12.4%, though only half of that comes out of your paycheck – 6.2%. The other 6.2% is paid by your employer on your behalf. (This is related to, but separate, from Medicare taxes). Self-employed people have to pay both halves of this.
OASDI taxes may not apply to all of your earned income — as of 2015, it applies to the first $118,500. When the program started in 1937, it applied only to the first $3000 of earned income. The “cap” increases every year and is intended to keep the program’s funding on track along with the growth of wages over time.
The amount of wages on which you paid SS taxes is your “covered” earnings.
Once you’ve participated in the program for enough time to qualify for benefits (10 years), your benefits are computed based on the average of your highest 35 years of “average indexed monthly earnings” (“AIME”) — which means historical earnings are adjusted to take into account wage growth over time.
If you worked for less than 35 years, they still add up all the years you worked and divide by 35. If you worked more than 35 years, they drop off your lowest-income years.
From the AIME, they compute your Primary Insurance Amount (“PIA”). To simplify the math, we are going to modify the actual bend-points involved (these are close, but have been rounded — to $800 and $5000. (The actual numbers in 2015 are $826 and $4980, and they get adjusted every year.). The factors, however, are correct, at 90%, 32% and 15%.
The PIA is computed by slicing up your average monthly earnings as follows:
PIA = 90% of the first $800 plus 32% of the next $5000 plus 15% of the remainder (up to the maximum)
So if a worker’s average indexed monthly earnings (AIME) was $1000/mo, the benefit he or she would receive at full retirement age under the (approximate) current formula we are using for our example would be:
PIA($1000) == ($800 * 90%) + (($1000-$800) * 32%) == ($800 * .9) + ($200 * .32) == $720 + $64 == $784/mo. (78.4%)
If a worker’s average indexed monthly earnings was $6000/mo, the benefits he or she would receive is:
PIA($6000) == ($800 * 90%) + ($5000 * 32%) + (($6000 – $5800) * 15%) == $720 + $1600 + ($200 * .15) == $720 + $1600 + $30 == $2350/mo.(39.2%)
And at $9000 (we can’t go to $10,000 because taxes are capped at $118,500/yr now, so it’s not possible to currently have an AIME of $10,000):
PIA($9000) == $720 + $1600 + (($9000 – $5800) * 15%) == $720 + $1600 + ($3200 * 0.15) == $720 + $1600 + $480 == $2800/mo (31.1%)
If that worker starts benefits earlier than full retirement age, the monthly benefit will be reduced for life. If that worker delays starting benefits until after those benefits will be increased for life.
Note that the formula for benefits makes Social Security a steeply progressive program. Taxes are collected with a flat tax, but benefits (as a percentage of income which was taxed) are much higher for lower income people than for higher income people. The PIA($1000) replaces more than 78% of that worker’s income while the PIA($6000) replaces only just over 39% of that worker’s income even though they paid exactly the same tax rate on their covered income.
Survivors benefits are additional benefits which, when added to the surviving spouse’s existing benefits, are enough to bring up the surviving spouse’s benefits in total to equal the greater of the two spouse’s benefits. For example, if you are collecting $1000/mo and your spouse was collecting $1500/mo, if your spouse dies, you’ll continue to collect your $1000/mo plus a survivor benefit of $500/mo so your new total is the same as the greater of the two previous benefits.
In addition, but less commonly claimed, there are both survivor’s benefits for folks who die younger, and benefits available to young children:
Survivor’s benefits for a surviving spouse of someone who’d qualified for Social Security but died prior to reaching full retirement age are somewhat complex. The rules applying to that depend on all the factors discussed above regarding the primary insurance benefit of the deceased, as well as the age of the surviving spouse and whether there are any children involved, and these rules may also apply to a surviving divorced spouse.
Children’s benefitsmay also be available if your children (or step-children!) are unmarried and below certain ages (usually 18) (or disabled). If the parent is disabled, or retired and entitled to Social Security benefits, the children are each entitled to an additional benefit equal to up to 75% of the parent’s benefit (subject to a total family maximum (which is from 150% to 180% of the parent’s “full” benefit amount). Children’s benefits stop when the child reaches 18 (or 19 if a student no higher than 12th grade) (except, again, for disabled children whose benefits may continue, though the disability must have started before age 22). Children’s benefits may also continue as survivor’s benefit.
What are WEP and GPO?
WEP is the “Windfall Elimination Program” and is intended to offset the fact that the SS payouts are steeply progressive. If a worker was covered by another pension (in lieu of paying Social Security taxes), the steeply progressive payout would mean that such a worker may have a higher total pension income (from the combination of SS and their other pension) then they’d have had if it were all just one or the other program. So in order to account for that, the WEP takes that first factor — 90% (of the first $800) and reduces the factor to as low as 40% instead (depending on how many years of covered “substantial” income the worker had — the reduction may be down to 80%, for example, but it never goes below 40%). Note that the formula is still steeply progressive. The worst possible impact of WEP — the loss of $400/mo — only applies if the worker is getting another pension — and even so, if we apply the worst possible WEP “penalty” to those three example workers above, and you can see that the benefit formula remains progressive (lower-income folks get a higher proportion of their income replaced):
PIA($1000 with worst WEP) == ($800 * 40%) + $64 == $320 + $64 == $384/mo (38% income replacement)
PIA($6000 with worst WEP) == ($800 * 40%) + $1600 + $30 == $1950/mo (32.5% income replacement)
PIA($9000 with worst WEP) == ($800 * 40%) + $1600 + $480 == $2400/mo (26.7% income replacement)
Finally, the amount by which WEP reduces your Social Security is limited to no more than one half of the amount of your pension. If your pension from non-SS-covered earnings (i.e., a teachers’ pension) is, say, $600/mo, then even if the WEP formula specifies that you are to lose $400 of the benefits you’d otherwise collect, you will only lose $300. You cannot end up with less in SS+pension than you’d have had with the pension or the SS alone.
GPO is the “Government Pension Offset” and it may reduce one’s “spousal” benefits if one is covered by another government pension. The WEP affects benefits earned under your own income and GPO affects benefits collected based on your spouse’s income. Once again, this is an offset put in place to account for the fact that one’s personal SS benefit would reduce a spousal benefit, so if one is covered by a government pension, it’s intended to mimic that effect (i.e., to keep people from “double-dipping”).
GPO’s computation is simply that your spousal benefit, if you are entitled to one, is reduced by 2/3 of whatever other government pension you collect.
So, for example:
If your spousal benefit (usually 1/2 of the benefit your spouse earns on his or her own record) were going to be $1000/mo, but you have your own government employee pension which pays you $600/mo, then your spousal benefit of $1000 will be reduced by (2/3 * $600) == $400 — you then collect your $600/mo pension plus a (reduced) spousal benefit of ($1000-$400) == $600 — for a total of $1200.
If your own pension benefit is significantly higher than your spousal benefit, you may lose the spousal benefit entirely:
If your spousal benefit were going to be $1000/mo, but you have your own pension of $2000/mo, your spousal benefit would be reduced by (2/3 * $2000) == $1333. But they can’t make it negative, so you simply don’t get the spousal benefit in this case.
While this may seem entirely unfair, it’s really no different from if you were getting your own social security benefit — you typically take whichever is higher — your spousal benefit or your own benefit. If your own benefit is higher than your spousal benefit, you effectively don’t get that spousal benefit. In that second example, suppose your spousal benefit were $1000/mo and your own Social Security benefit were $2000/mo. You’d take the higher benefit – your own $2000/mo. — and no spousal benefit. Exactly the same outcome.
Spousal benefits were intended to take care of stay-at-home spouses who were financially dependent on their working spouse. If both spouses worked and earned their own benefits, they simply each collect their own benefits. In fact, the earlier example — where the spouse covered by a smaller government pension still collected partial spousal benefits — indicates that the program still helps out lower-earning spouses by giving them benefits that unmarried folks never get (and possibly even benefits that they’d not have gotten if they’d earned the same thing under Social Security-covered employment).