Apply the Social Security Benefit Formula to Individual Years of Earnings

A two-step process is used to calculate Social Security benefits. First, a worker's average indexed monthly earnings, or AIME, is computed. For a retired worker, the AIME is calculated on the basis of the highest 35 years of earnings on which Social Security taxes were paid, with earnings included up to the taxable maximum, which in 2011 is $106,800. Earnings before age 60 are adjusted by growth in the average wage index (AWI), which is the average of all earnings in the U.S. economy; earnings after age 59 enter the computations as actual amounts. (As a result, for someone born in 1925 or later, earning $10,000 in 1974 had the same effect on benefits as earning $20,000 in 1984 because the AWI doubled over the course of that period.) Second, a progressive benefit formula is applied to the AIME to arrive at the primary insurance amount (PIA), the sum that is payable each month to a worker who begins receiving Social Security retirement benefits at the full retirement age, currently 66. For workers who turn 66 in 2011, the PIA formula is 90 percent of the first $680 of the AIME, plus 32 percent of the AIME between $680 and $4,100, plus 15 percent of the AIME above $4,100.

Under the PIA formula, benefits replace a larger share of average career earnings for people with lower earnings than they do for people with higher earnings. For example, the benefit for someone with very low earnings is 90 percent of that person's AIME, but the benefit for someone with earnings above the taxable maximum for 35 years is about 28 percent of the AIME.

This option would essentially reverse the order of the computation: A progressive benefit formula would be applied to each year of indexed earnings, and the PIA would be equal to the average of the annual PIAs. As under current law, this option's benefit formula is progressive, although it would apply that progressivity to annual earnings rather than to lifetime earnings. The change would reduce federal outlays by about $15 billion over five years and by almost $89 billion through 2021. By 2050, Social Security outlays would be reduced by 5 percent--from 5.9 percent to 5.6 percent of gross domestic product.

Under this option, almost all workers' PIAs would be lower than they are under current law, but the reduction would be steeper for people whose earnings varied more from year to year, including people who were out of the workforce for many years. There would be no change in benefits for a worker whose earnings were equal to (or a constant proportion of) the AWI in every year of work. But benefits would fall substantially for someone with high earnings in some years and no earnings in others. For example, compare the case of a "steady earner" who has earnings equal to the AWI for 35 years or more with the case of a "short-career worker" who earns the same average wage when working but works for only 10 years. Even though that worker has average earnings during 10 years of employment, his or her lifetime earnings are quite low because of the 25 years of zero earnings. Under current law, the progressive benefit formula is applied to that low level of lifetime earnings (as measured by the AIME), and the short-career worker's Social Security benefit will replace almost 80 percent of his or her average lifetime earnings. Under this option, the benefit formula would be applied to the worker's average earnings while working, and the progressive benefit formula would replace just 45 percent of those earnings. Thus, this option would have no effect on the steady earner, but it would reduce the benefits of the short-career worker by more than 40 percent.

A rationale for this option is that it would encourage some people to work longer, which would increase the size of the workforce and boost federal revenues from income and payroll taxes. Also, the additional work would result in higher future Social Security benefits. The 10-year estimates for this option do not include those two effects.

When weighing the decision to retire, people may consider how the timing of retirement will affect Social Security benefits. Under current law, one additional year of work by someone who had worked for fewer than 35 years would in most cases increase annual benefits by 32 percent or 15 percent of the year's earnings divided by 35, because most workers have an AIME that is in the 32 percent or 15 percent bracket of the PIA formula. Under this option, the worker's benefit would increase by a larger amount, because at least part of the earnings in that additional year would fall in the 90 percent bracket. Consider a worker who worked 34 years at average wages. Under current law, a 35th year of work would increase annual benefits by about $375, but under this option it would increase benefits by about $525.

An argument against this option is that a worker's ability to save for retirement depends on lifetime earnings, not annual earnings. People with more volatile earnings histories, who would experience the largest reductions in benefits, tend to have low lifetime earnings. Benefits would decline by about 15 percent, on average, for beneficiaries in the lowest quintile--or fifth--of lifetime household earnings. In contrast, benefits would fall by about 8 percent for people in the second-lowest earnings quintile and by 5 percent for groups with higher lifetime household earnings.