Will the President’s Proposal Solve Social Security’s Crisis?

Policy Reports | Social Security

No. 280
Wednesday, November 16, 2005
by Andrew J. Rettenmaier and Thomas R. Saving

The Current Law Benefit Formula

Table I - Average Indexed Monthly Earnings and the Primary Insurance Amount for 2005 Retirees

To understand how progressive price indexing works we must first understand how Social Security benefits are calculated. Currently, the Social Security Administration examines a worker’s earnings history — an individual record of past annual earnings for all years in which Social Security taxes were paid — and identifies the 35 highest-earning years after the earnings have been adjusted by a wage index. Past earnings are indexed upward by the growth in wages each year. These indexed past earnings are then averaged to produce a worker’s average indexed monthly earnings (AIME). [See the appendix for more details.]

A formula is then used to covert the AIME into a recipient’s monthly benefit, referred to as the primary insurance amount (PIA). PIAs for low income workers represent a higher percentage of their AIMEs than do the PIAs for higher income workers. The replacement rate — Social Security benefits as a percent of preretirement indexed earnings — is determined by the relationship between a worker’s AIME and the PIA formula, which produces progressively lower replacement rates as the AIME rises.

  • Under current law, for example, lower-wage workers retiring this year can expect Social Security to replace 58.3 percent of their preretirement earnings.
  • The replacement rate for middle- and higher-income workers is 43.6 percent and 36.1 percent, respectively.
  • Because of the redistributive nature of the current system, workers who earn the maximum taxable wages can expect a replacement rate of only 30.1 percent.

Figure I - The Relationship between Average Indexed Monthly Earnings and Social Security Benefits

The formula has two “bend points” that rise with the increase in average wages. The bend points are established in the year a worker becomes eligible for early retirement benefits (currently at age 62). Thus, workers reaching normal retirement age this year will retire with bend points established in 2002.

  • For AIMEs below the first bend point — $592 in 2002 — each additional dollar of average wages increases the monthly benefit by 90 cents.
  • Between the first and second bend points — from $592 to $3,567 in 2002 — an additional dollar of average wages increases monthly benefits by 32 cents.
  • Finally, each additional dollar of average wages above $3,567 increases monthly benefits by 15 cents.

Table I gives a few examples of the relationship between AIME and PIA amounts for retirees in 2005 who had very low, low, medium and high lifetime earning as well as for those who earned the taxable maximum in each year. As illustrated in Figure I and presented in Table I, retirees with higher earnings have lower replacement rates than do lower income retirees. Recognizing the redistributive nature of the current formula is helpful in understanding the effects of progressive price indexation for different income classes and how PRAs can fill the gap in benefits.

Read Article as PDF