If you were born in the year 1960, you should be breathing a sigh of relief. The reason for this relief has to do with how Social Security benefits are calculated. The national average earnings in the year in which you turned 60 – 2020 for workers born in 1960 – is critical in calculating your base monthly benefit. If wages go up in the year you turn 60, your base Social Security benefit goes up, but if wages go down in that year, your base benefit goes down. Last year, with the global pandemic and the resultant economic shutdowns, it looked as though the national average wage for the year was destined to fall relative to 2019. This portended lower base Social Security benefits for people born in 1960. However, the recently released national average wage for 2020 did not decline, but actually rose 2.83%.
To see how the average wage in the year you turn 60 affects your initial benefits, let’s consider the following example calculations for hypothetical workers born in 1960. Each year, actuaries in the Social Security Administration’s Office of the Actuaries produce a set of factors that can be used to calculate earnings histories of hypothetical workers with very low, low, medium, and high earnings.
These hypothetical earnings profiles, along with the earnings at the taxable maximum, are depicted in the figure below.
The first step in determining workers’ Social Security benefits is converting their nominal, or current year, earnings into wage-indexed earnings. The wage index for each birth year is equal to the ratio of the national average wage in the year a worker turns 60 divided by the average wage at each age up to the age of 60. The recently announced average wage for 2020 was $55,628.60. So, for example, the wage index value at age 21 for workers born in 1960 is equal to the wage at age 60, $55,628.60, divided by the national average wage in 1981, 13,773.10, or 4.04. This value is multiplied times the nominal wages in Figure 1 at age 21 to produce the wage indexed earnings at that age in Figure 2. Similarly, the index values at all other ages less than 60 are multiplied times the respective nominal wages to produce the indexed wages. The wage index at age 60 is 1 and the Social Security formula sets the value to 1 for all ages above 60. Earnings at younger ages are increased by both price level changes, inflation, and real wage growth. Figure 2 shows how wage-indexing increases the nominal wages from Figure 1.
The next step in the Social Security benefit calculations is determining workers’ average indexed monthly earnings (AIME). This average is equal to the sum of workers’ 35 highest annual earnings divided by 420, the number of months in 35 years. Typically, workers’ highest earnings are at older rather than younger ages, but it depends on the worker. If a worker has less than 35 years of earnings, zeros are entered into the AIME calculation. The worker’s AIME is then used to calculate the worker’s benefit or Primary Insurance Amount (PIA). We’ll discuss the calculation of the PIA below.
Workers’ PIAs are the monthly benefits they receive if they begin claiming Social Security benefits at the normal retirement age, which is 67 for workers born in 1960. Workers can begin claiming benefits when they reach 62 years of age, but at a reduced rate. They can also delay claiming benefits to age 70 and are rewarded with higher monthly benefits.
So, what would have happened to the indexed earnings had wages fallen in 2020 rather than rising? A letter from the Congressional Budget Office’s (CBO) Director Phillip Swagel to Chuck Grassley, the then Chairman of the Senate Finance Committee, dated January 27, 2021, estimated that the national average wage would decrease 0.5% in 2020.
This estimate was smaller than the CBO’s earlier estimate from September 2020 of a 3.8% decline. We’ll used these two estimates to illustrate how Social Security benefits are negatively impacted by lower national average wages in the year one turns 60.
Figure 3 shows the wage-indexed earnings for a medium worker born in 1960 based on the realized wage growth of 2.83% from 2019 to 2020 and the CBO’s two wage estimates of -0.5%, and -3.8%. As is clear from the figure, had the lower wage growth rates for 2020 been realized, the past indexed wages would not have been as high and, consequently, the medium worker’s AIME would have been lower as would the benefits based on those indexed earnings.
Table 1 quantifies the degree to which the lower wage growth rates over the past year would lower workers’ average indexed monthly earnings. For this table, we assume workers work continuously until the age of 66. To put the indexed monthly earnings in perspective, the annualized earnings for very low earning workers is $14,036, for low earners is $25,264, for medium earners is $56,142, for high earners is $89,825, and for workers at the taxable maximum for 35 years is $141,042, based on the realized wage growth of 2.83%. For medium earning workers, had a -0.50% growth in wages between 2019 and 2020 been realized, their AIME would have been $151 dollars less per month relative to the AIME based on the actual growth rate of 2.83%. Had a -3.80% growth in wages between 2019 and 2020 been realized, their AIME would have been $301 dollars less per month.
A worker’s AIME is converted to their primary insurance amount (PIA) using a benefit formula that replaces a decreasing percentage of indexed earnings as workers’ earnings rise. For workers born in 1960, the formula replaces 90% of indexed earnings up to $1,024 (the first bend point), 32% of indexed earnings up to $6,172 (the second bend point), and then 15% of earnings above $6,172 up to the indexed taxable maximum. The two bend points are also indexed to the national wage and are lower if wage growth is lower. Table 2 shows how the PIAs are affected by the different wage growth rates. The estimates in the table for the lower wage growth rate use lower bend points.
Again, consider the medium earners - these workers’ monthly benefit would have been $68 dollars lower had wages fallen 0.50% and $135 lower had wages fallen 3.8%. High earning workers’ monthly benefits would have been $89 and $178 lower had wages fallen 0.5% and 3.8%, respectively. These monthly differences may seem small, but they add up over one’s retirement.
Table 3. presents the present value of benefits at age 67 assuming the workers receive benefits for 19 years. We also assume that the real discount rate is 2.5%. From the table we see that the realized wage growth results in lifetime benefits for medium earning workers that are $12,251 higher than they would have been with the -0.50% wage growth and $24,436 higher than they would have been with -3.80% wage growth. For high earners, lifetime benefits are $16,222 and $32,332 higher.
This past year brought with it great concerns about how the economy would fare in light of the pandemic-induced recession. During 2020, it looked like wages were going to fall with the massive increase in unemployment. However, in retrospect, the official recession was short, and wages grew. As we have seen, wage growth in the year you reach the age of 60 ultimately affects your monthly Social Security benefits. For average workers born in 1960, the realized higher wage growth will result in between $12,000 to $24,000 more in lifetime benefits than if had wages fallen in 2020 at the rates that had been estimated over the course of the past year. For couples with two medium earners who were both born in 1960, the amounts would be double. The recently announced growth in the Social Security average wage between 2019 and 2020 is definitely welcome news for workers born in 1960.
See Michael Clingman and Kyle Burkhalter, “Scaled Factors for Hypothetical Earnings Examples Under the 2021 Trustees Report Assumptions,” Socials Security Administration, Actuarial Note, Number 2021.3, August 2021.
Letter to Chuck Grassley from Congressional Budget Office Director Phillip L. Swagel, Re: The National Average Wage Index in 2020
, January 27, 2021.
See Congressional Research Services, “Social Security: The Effects of Wage and Price Indexing on Benefits,” June 16, 2021, for AIME and PIA estimates for a range of wage growth estimates.