One issue which we address on a regular basis is how one’s future Social Security benefits will be computed. Sure, you get a periodic statement from the SSA indicating what your benefit will be if you continue working to 62, to your full retirement age (might be as high as 67) or to 70. And they tell you those benefits in today’s dollars.

But how did they come up with those numbers? And how will changes in your income, or retiring early, or getting married (or divorced!) affect your benefits? And will they go up in time with inflation? A dollar today sure won’t buy a dollar’s worth of goods 20 years from now – so how will your SS benefit be affected by that?

Inflation

There’s a lot to digest here, so first let’s dispense with inflation adjustments. The short story is that you don’t need to worry much about inflation eating into your future Social Security benefits, and in fact, you are likely to get more than you’d need to keep up with inflation. And there are two reasons why.

First, if you are not yet collecting benefits, your future benefits are not actually inflation adjusted. They are adjusted higher than inflation — they are adjusted by a national average wage index. This is because when your primary benefit computations are made, they take your entire earnings history and wage-growth adjust it all to be in equivalent dollars to the wage base in the year you turn two years prior to when you are first eligible for benefits (which, since most people are eligible at age 62, means the year in which you turn 60). Just how big a difference has this made historically? Historically, the wage base has grown be more than 1% more than inflation. For example, the wage base in 1994 was $60,600. If that had simply gone up with inflation (measured by the CPI), it would be about $107,000 in 2021. However, they do not adjust it by the CPI. They adjust it by wage growth. And the Social Security wage base in 2021 is therefore $142,800. That’s a huge difference — compounding at over 1% more per year than inflation. In other words, future Social Security benefits — at least until you start actually collecting them — have historically gone up by substantially more than inflation.

(Source: SSA.gov)

Second, if you are already collecting Social Security benefits — those benefits are also adjusted annually for inflation. This time, however, the adjustment is based on the CPI-W — the Consumer Price Index for Urban Wage Earners and Clerical Workers.

Benefit Computation

Your actual benefit starts with computing a PIA – a Primary Insurance Amount – which is constructed by applying a formula to your average indexed monthly earnings. Understanding this computation is essential to understand how changes in your income — or retiring early — will affect your future benefits.

So we’ll start with what that average indexed monthly earnings is. As noted above, your history of covered earnings is all wage-growth adjusted. So if you earned $60,600 in 1994, and you earned $142,800 in 2021, and were doing the computation in 2021 — both years would be treated exactly equally — as $142,800. After adjusting all of your historical earnings into equivalents for the base year — your 35 highest earnings years are averaged. If you have fewer than 35 years of covered earnings — it’s still a 35 year average and they factor in zeros. If you have more than 35 years, only the 35 highest earning years count. If you have 35 or more years at or above the SS wage base cap, congratulations, you’ll be getting the highest possible benefit there is. Note that once you’ve reached that cap, that’s all there is. Someone who made $1,000,000/yr for 35 years gets exactly the same benefit as someone who earned exactly at the cap each year of his earnings history. (And, notably, they paid exactly the same in Social Security taxes, too).

(Note that when the Social Security Administration computed your projected benefits on that statement they sent you, they assumed that whatever you earned in your last covered year — you keep earning that all the way until you start collecting benefits. This could inflate the average a bit if you retire sometime before you start collecting those benefits.)

After computing your 35 year average indexed monthly earnings — meaning that they take that annual average and then divide by 12 — your actual benefit is computed by applying a formula with two important bend points.

Using the 2021 wage base of $142,800 for the example computation — to see the highest possible benefit that could be computed today — we note that the monthly average is $11,900.

The actual computation (with some rounding), then, is as follows:
the PIA — the Primary Insurance Amount — meaning your base monthly SS benefit is
(a) 90% of the first $996 == $896
(b) 32% of the amount between $996 and $6002 (32% of the next $5006) == $1601
(c) 15% of the rest from $6002 up to the cap of $11,900 (15% of the next $5898) == $884
=====> the maximum base PIA in 2021 is therefore $3383

Let’s do the same calculation for someone who’d earned $6000/mo on average after the adjustments:
the PIA($6000) is
(a) 90% of the first $996 == $896
(b) 32% of the next $5004 == $1601
=====> PIA($6000) == $2497

There are some important things to note here. This formula is steeply progressive — meaning that the benefit received by lower-earning people is much much higher relative to their incomes on which they paid Social Security taxes — than for higher income people. In fact, someone’s who earned half the SS wage base for his or her entire career — and therefore paid precisely half as much in Social Security taxes — would get nearly 74% of the benefits that someone who earned the maximum would get. This is not an accident. This is a feature of the program, which is intentionally structured to be redistributive from higher income people to lower income people.

This also means that, at the margin, if you have earned half of the maximum — or you have a number of high income years, but end up with fewer than 35 years of covered earnings — your benefit loss from not reaching the maximum is going to be pretty moderate.

Consider, for example, if you’d earned (and paid) the maximum for 30 years and retired early, rather than continuing to earn (and pay) the maximum for 35 years. Using 2021 numbers, your monthly average covered earnings would be (30/35) * $11,900 == $10,200. That’s a significant drop of over 14% in covered earnings! However, your benefit, using the preceding computation, will have gone down from $3381 to $3126. Your covered earnings were lower by 14%, but because those benefits, at the top end, are computed based on only 15% replacement — your actual benefits dropped by about 7.5%

Note that Social Security replaced only 28% of the covered earnings of the highest income person. It replaced over 40% of the covered earnings of a middle-income person.

Marriage and Divorce and Death

Sadly, this is the portion we’re not going to get into much detail on, since the impact, particularly where there are two income histories to factor in, can be quite complex. And it gets even messier to factor in deaths!

However, here’s the short story:

(a) If you are legally married at the time you apply — and have been legally married for a full continuous year before that — you may apply for spousal benefits — a benefit based not on your own earnings history, but rather, on the earnings history of your spouse. You do not have to have earned anything nor paid a penny of Social Security taxes to collect this benefit. The basic spousal benefit is one half of the PIA of the spouse on whose record you are applying to collect benefits. (You may collect these benefits as early as 62, but they will be reduced if you claim them before your full retirement age, which for most people is now between 66 and 67). Collecting spousal benefits has no impact on the benefits of the spouse on whose earnings record you are collecting. It’s entirely additional. The primary earner’s benefits are not reduced in any way by a spouse collecting benefits on that record. Note, however, that unless your spouse is collecting benefits, you may not start collecting spousal benefits. So if your spouse was delaying collecting benefits, you may need to similarly delay collecting spousal benefits. Whether it makes sense to delay or not is a complex calculation.

(b) If you are divorced — you are entitled to spousal benefits based on your ex-spouse’s earnings record — if you were married for 10 years. This doesn’t phase in or out — 9 years and 11 months ==> nothing; 10 years and a day ==> the whole shebang. Moreover, if you are divorced, unlike if you are married, you may collect spousal benefits even if the ex-spouse has not started collecting benefits. And, finally, more than one person may collect spousal benefits on the same earner’s record — if each of the ex-spouses were married for that full 10 years. If someone has been divorced twice — each time having been married more than 10 years, and then got married a third time, it’s possible for that person to collect full individual benefits and have three people collecting spousal benefits at the same time on that one person’s earnings history!

(c) If you are entitled to a spousal benefit, but have your own earnings history, too — you will generally collect whichever benefit is higher. There are some quirks wherein it’s possible to claim a lower benefit and later switch to a higher benefit and this type of timing and optimization of benefits may be valuable. However, the basic default claiming structure is you simply get whichever is higher. If your own earnings record was, say, half the cap over a full career, and your spouse earned at the cap for a full career — as noted above, your earnings record will get you a benefit approximately 3/4 of the maximum — and substantially higher than the spousal benefit of only 1/2 would have been.

(d) Finally, if you and your spouse are both collecting benefits, after the first of you dies, the survivor may be entitled to survivor benefits. If the first person to die was the one with the lower benefit, the survivor simple continues collecting the higher benefit he or she was already collecting. However, if the first person to die was the one with the higher benefit, the survivor will collect a survivor benefit such that the ongoing benefits will add up to that higher benefit. Effectively, whichever spouse dies first, the survivor collects the higher benefit for the rest of his or her life. The first death effectively means the loss of the lower benefit, regardless of which spouse actually dies first.

Run The Numbers

Ultimately, Social Security benefits are some of the most complex financial structures we’ll encounter in our lives. We do our best to optimize benefits claiming strategies, but some factors are outside of our control (most notably, life expectancy!). However, we encourage everyone to understand the basics of how their benefits will be accruing. This is an important element in your much larger overall lifetime financial profile, and we strongly encourage both modeling your Social Security benefits with optimizations taking as much of this into consideration as possible — and making sure that it fits into your larger financial picture. Nothing here should be construed as specific financial planning advice and we recommend consulting with qualified professionals. Run the numbers. Don’t just rely on the defaults. And remember, the Social Security Administration is also not necessarily going to tell you the best claiming strategies, either.

Additional resources:

https://www.ssa.gov/OACT/COLA/AWIgrowth.html

https://www.ssa.gov/OACT/COLA/Benefits.html

https://www.ssa.gov/cola/