How are earnings used to figure Social Security retirement benefit?

The answer to yesterday's multiple choice question is: d) Your Social Security retirement benefit will be based on your highest 35 years of lifetime earnings.

When you apply for retirement benefits, Social Security will look at all of your yearly earnings, index them to the national wage index for the year you turned age 60, and select the highest 35 yearly amounts. These are then averaged and converted to a monthly amount called an Average Indexed Monthly Earnings (AIME) which is then used to figure your monthly benefit. The higher your AIME is, the higher your benefit will be.

When planning your retirement date, keep in mind that working even a year or two longer may increase your benefit if those extra earnings are higher than the lowest yearly earnings used in your 35 year average!

Social Security Multiple Choice

Many times people ask me if retiring early will make a difference in their Social Security benefit. I have found that most people do not know how Social Security uses their earnings to figure their benefits.

So here's a multiple choice question to test your knowledge. Your Social Security retirement benefit will be based on:

a) your last 5 years of earnings before you retire

b) your highest 5 years of lifetime earnings

c) your last 10 years of earnings

d) your highest 35 years of lifetime earnings

Make your choice and check for the answer tomorrow!

Will Social Security change in the future?

Yes, Social Security will continue to change in the future as it has over its nearly 75 year history. Exactly what these changes will be no one knows for certain, but there have been several proposals made to address the need to pay benefits to a growing number of retirees who are expected to live longer than earlier generations.

First, proposals that reduce the growth in future benefits:

1. Change cost of living adjustments (COLA) so that future increases would be somewhere between 0.5% and 1% less than under current law.
2. Change benefit formulas for future retirees to average 40 years of earnings (rather than the current 35 years) or adjust benefit rates in other ways that reduce average benefits.
3. Phase in a higher Full Retirement Age (FRA) of 68 or higher for future retirees.

Finally, proposals that increase future revenues to pay for benefits:

1. Raise the maximum earnings subject to Social Security taxes (currently $106,800) faster than under current law or eliminate the maximum entirely.
2. Increase payroll tax rates for employers and/or employees.
3. Require that all state & local government employees be covered under Social Security(under current law participation by state & local governments is voluntary).
4. Invest Social Security trust funds in marketable securities to potentially increase future income to the fund.
5. Increase taxation of Social Security benefits; currently about 1/3 of all beneficiaries pay some income tax on their benefits.

What will the final plan to refinance Social Security look like? I am sure that it will include at least some of these proposals. There could also be provisions for a voluntary "personal account" that would include an offset of traditional Social Security benefits at retirement if a worker chooses to participate.

When people ask me if Social Security will be there for them I say yes and I really do believe it. But I can't help thinking about the verse from a Joni Mitchell song, "Don't it always seem to go, that you don't know what you've got till it's gone." So boomers, pay attention! We all have a lot to lose.

Will Social Security be there for me when I retire?

The short answer is yes, it will. The long answer is a little more complex and requires (forgive me) a bit of background before I get to the bottom line.

Social Security has never been an individual investment account like a 401(k). It is more like a defined benefit pension that covers about 95% of wage earners and the self-employed in the U.S. and is not tied to any one employer. Both the employer and employee contribute to the Social Security trust fund and employees are vested for a retirement benefit payable as early as age 62 based on their earnings under the system. Part of the Social Security tax also is used to provide disability benefits to workers who are unable to work due to illness or injury and to qualified family members of workers who die (widow or widower, minor or disabled children).

For over 70 years, the Social Security Administration has paid benefits from current year tax revenues. Excess revenues not needed to pay benefits are credited by Treasury to the Social Security Trust Fund and held in special issue government securities until they will be needed to pay future benefits. According to the Social Security Administration, the Trust Funds earned an effective interest rate of 5.1% in 2008.

In spite of expected increases in the number of retirees as baby boomers reach retirement age, the Social Security trustees report that current year tax revenues plus interest will be sufficient to pay 100% of benefits until 2027. At that point, Social Security will have to start drawing on the trust funds to supplement revenues. By 2041 the trust funds will be depleted and current revenues will cover about 78% of benefits if nothing is done between now and then.

Click here to see charts based on 2008 Social Security Trustee Report.

So the fact is that in the short term, the Social Security programs have a substantial surplus but there are long term challenges that must be addressed to keep the program solvent over the long term for generations to come.

And here we are at the bottom line: if we want Social Security to be there for our children as it has been for our parents and grandparents, there will have to be changes.

Stay tuned for some of the solutions that have been proposed....

Are annual cost of living raises in Social Security guaranteed?

Since 1983 annual cost of living raises for Social Security benefits have been paid based on the average % increase in the CPI-W (consumer price index for urban workers) in the third quarter over the average CPI-W in the 3rd quarter of the previous year. The COLA paid in January 2009 was 5.8% and the average over the past 20 years has been 3% per year.

The automatic COLA provisions provide retirees an important protection against the erosion of their standard of living due to inflation. For example, if the average COLA continues to be about 3% for the next 20 years, a monthly benefit of $1000 in 2009 would be increased to about $1806 in 2029.

But as we all know, these are not normal economic times. What happens if the CPI-W continues to decline as it as done since the 3rd quarter of 2008?

If that happens, Social Security benefits would not be decreased, but there would be no automatic COLA raise in January 2010.