In my work as a financial planner, there’s one topic that always seems to raise an eyebrow: Social Security. When people see projections of future retirement benefits, oftentimes they respond with skepticism. My sense is that media reports questioning the solvency of the system have led people to discount the value of this benefit, or to disregard it entirely. In my view, this is a mistake. While no one can guarantee what Social Security will look like in the future, I do believe it is important to understand the basics of how the system works. This understanding may help you maximize your own benefits and avoid costly mistakes.
Social Security is complex, with thousands of rules, but it is not hard to understand the calculations behind the standard monthly retirement check. There are just three main factors:
1. Primary Insurance Amount: Each retiree’s check will vary in relation to the amount that they paid into the system during their working years. The Primary Insurance Amount, or PIA, is the amount that you would receive if you opted to start benefits at what is called Full Retirement Age, between 65 and 67 — more on this below. There are three important things to know about the PIA. First, in most cases, you need to work for at least ten years (or technically, 40 quarters) in order to be eligible for any benefits at all. Second, once you have accumulated those 40 quarters, Social Security will calculate your PIA based on your average earnings over your 35 highest-earning years. If you have fewer than 35 years of earnings, the government will average in zeroes for those years. The third point is that, during your working years, Social Security only taxes your earnings up to a certain level (which adjusts each year with inflation). As a result, during retirement, your benefit also will be capped. This year, for example, the income threshold is $128,400. Whether you earn $128,400 or $500,000 or a million, your retirement check will be the same.
To provide a simple example of the calculation, suppose you are nearing retirement, and your career earnings, adjusting for inflation, have averaged $150,000. Here’s how Social Security would calculate your PIA:
90% of your first $895 of average monthly earnings: $805.50
32% of the next $4,501 of earnings: $1,440.32
15% of the final $5,302 of earnings (that is, up to the cap): $795.30
Put that all together, and your total monthly benefit at your Full Retirement Age would be $3,041, or $36,493 on an annual basis.
2 . Full Retirement Age: Above, I mentioned the term Full Retirement Age, often abbreviated FRA. This is the age at which you are entitled to receive a check equal your Primary Insurance Amount. FRAs vary based on when you were born. When Social Security began in the 1930s, everyone’s FRA was 65. Over time, however, as Americans’ life expectancies have increased, Congress has gradually increased FRAs up to 67, so younger people will have to wait a little longer to receive their full benefits. You can look up your own FRA on the Social Security website.
3. Age at which you choose to start receiving benefits: At your Full Retirement Age, you are entitled to a check in the amount of your Primary Insurance Amount. However, you have the option to start receiving benefits as early as 62 or as late as 70. If you opt to start earlier, your check will be reduced substantially below your PIA. Or, if you are able to wait additional years beyond your FRA, your benefit will increase substantially — about 8% per year for each year you wait. Continuing with the above example, if your FRA is 67 and you are able to wait until 70, your benefit would increase by 24%, to about $3,771 per month or $45,252 per year. Of course, you would receive those checks for fewer years, and this is something to consider if you have health concerns. But, if you are generally in good health, you would reach a break-even point around age 78 and then come out ahead every year thereafter. For that reason, I always encourage people to wait until 70, if at all possible.
As I said, Social Security’s rules are complex. I have provided only a simplified example, but I hope this gives you a better feel for how the system works and, importantly, helps you to understand the levers available to maximize your own benefits. As a next step, if you haven’t already, I would definitely head over to socialsecurity.gov, where you can download an up-to-date copy of your statement, which will provide benefits estimates based on your own earnings history.