This week I’m jumping into the inner workings of Social Security to answer a question about the impact of early retirement on how much Social Security early retirees will qualify for.
The usual question is: “Yeah but if you retire early you won’t get hardly any social security and you’ll be poor when you’re older. You should keep working till a reasonable age like 67 so you can earn a good Social Security payment”. Okay, grammarians, I confess. That’s not really a question but rather a complaint in the form of a declarative sentence followed by another declarative sentence.
The short answer is that the complainant has no clue how Social Security works, because early retirees typically qualify for really great SS benefits given how little they work. The long answer involves bend points and understanding the progressive nature of the Social Security system. And math.
The Social Security Formula
Determining the amount one will receive from Social Security is fairly simple when reduced to its parts. Here’s how it works:
- Look at an entire lifetime of annual earnings (anything that was subject to SS taxes).
- Adjust each year’s earnings to account for inflation.
- Take the highest 35 years of inflation-adjusted earnings and discard the rest of the earnings (if any).
- Divide by 420 (35 years times 12 months) to get the Average Indexed Monthly Earnings (“AIME” in SS speak)
- Run the AIME Monthly Earnings through the Primary Insurance Amount (“PIA”) formula or “bend point formula” (which returns between 15% and 90% of each dollar of monthly earnings).
- Adjust the Primary Insurance Amount up or down to account for taking SS early (at age 62), at regular age (67 for everyone born in 1960 or later), or late (at age 70) or any point between age 62 and 70.
If you take SS at your full retirement age (assumed to be age 67 here for the purpose of simplicity), then you’ll be getting the Primary Insurance Amount from Step 5.
There are a few more complications to the way SS is actually calculated, mostly involving how inflation is applied in the various steps and which index is used for inflation (Average Wage Index versus CPI-W versus the more commonly used CPI-U). These complications are more interesting to economists than to the average person trying to understand how Social Security benefits are calculated, so I’m ignoring them because the impact is relatively minor and not relevant to the basics of how SS works at the big picture level.
To recap, your SS benefit is proportional to the average of the top 35 years of earnings. As your average monthly earnings increase, your SS benefit will increase, although to a lesser extent as you pass the 32% and 15% bend points.
What are bend points?
A picture is worth a thousand words (or at least a few hundred).
Bend points are the points in the Primary Insurance Amount formula where the rate of “payout” on an extra dollar of earnings decreases. Remember, Primary Insurance Amount is roughly the benefit you’ll receive at full retirement age (in today’s dollars).
Let’s take a look at the actual bend points in dollar terms to see what these bend points are all about.
For 2016, the two bend points are $856 and $5,157. When the Average Indexed Monthly Earnings falls below $856, the Primary Insurance Amount is 90% of the monthly earnings (AIME). For example, a $700 AIME generates a $630 PIA ($700 * 0.90 = $630).
When income falls between the two bend points, the Primary Insurance Amount equals 90% of $856 (the first bend point) plus 32% of everything over $856. For example, a $3,500 AIME generates a PIA of $1,616. Here’s the math: ($856 * 0.90) + ($2,644 * 0.32) = $1,616.
For AIME’s over $5,157, the Primary Insurance Amount is 90% of $856 plus 32% of $4,301 (2nd bend point amount minus first bend point amount), plus 15% of everything over $5,157. For example, the PIA on a $7,000 AIME = $2,423. Here’s the math: ($856 * 0.90) + ($4,301 * 0.32) + ($1,843 * 0.15) = $2,423.
Here’s the “payout” chart for various monthly earnings (AIME) amounts:
- AIME below $856 = 90%
- AIME over $856 and below $5,157 = 32%
- AIME over $5,157 = 15%
These bend points are analogous to income tax brackets because they are progressive in nature. Since we’re calculating a benefit instead of a tax, the rates are inverted. Instead of higher incomes paying more tax on the next dollar of earnings, higher incomes receive a smaller benefit on the next dollar of earnings.
The highest rate of benefit (90%) applies to the low income folks. Middle income folks are in the intermediate bracket with a moderate rate (32%). High income folks fall in the highest AIME bracket with the lowest rate (15%). That’s the nature of a progressive system – the worst off get the proportionally largest benefit.
Why earning more doesn’t pay off (much) when it comes to Social Security
Going back to the examples presented in the previous section, let’s look at how the Primary Insurance Amount increases as the monthly earnings increase.
- Below 1st bend point: AIME of $700 = $630 PIA (90% “payout”)
- Between 1st and 2nd bend point: AIME of $3,500 = $1,616 PIA (46% “payout”)
- Above 2nd bend point: AIME of $7,000 = $2,423 PIA (35% “payout”)
At $700 of monthly earnings, the monthly benefit is $630. Increase the monthly earnings by 400%, and the benefit increases by only 156% (to $1,616). Double the earnings again and the benefit increases just 50%.
By comparing the low income earnings with the high income earnings in this example, it’s a little more clear. $7,000 monthly earnings are 10 times the $700 monthly earnings, yet only generates a monthly benefit that is four times as great. Earning ten times as much while only receiving four times the benefits illustrates the progressive nature of the SS benefits formula perfectly.
The sweet spot is with the lower monthly earnings found below the first bend point of $856 where the benefit you earn is 90% of your earnings amount. Move up to the earnings range between the first and second bend points and you get 32% of each extra dollar of earnings (not great, but still something, right?). Go above the second bend point ($5,157+) and you only get 15% of each additional dollar of earnings (screw that!).
Understanding the Average Monthly Indexed Earnings (AIME)
Following me so far? If not re-read the last two sections because they are pretty dense.
The progressive nature of bend points and the average monthly earnings calculations are key parts to understanding how an early retiree fares under the SS benefits formula.
Let’s walk through some average monthly earnings examples. Remember, in SS parlance, the Average Indexed Monthly Earnings (AIME) represents the sum of the highest 35 years of income (indexed for inflation) divided by 420 (the number of months in 35 years).
Since the AIME takes an average of the incomes over 35 years, it doesn’t really matter whether the income occurs in a large dose over a relatively short period of time (like 10-15 years) or whether it’s evenly distributed over 35 years. Ignoring inflation, a person earning $70,000 per year for 10 years will have the exact same AIME as the person earning $20,000 per year for 35 years. The earnings for both people are $700,000 in total, $20,000 per year, or $1,667 per month. That $1,667 is the AIME.
In real life terms, an early retiree that worked as an engineer and averaged $70,000 per year over their 10 year career and then retired (not radically different than my own salary over my ten year working career before retirement) would have the exact same AIME as a fast food worker that earned $20,000 per year (about $10 per hour) over a much longer 35 year career.
It’s also worth pointing out the fact that Social Security only takes the highest 35 years of earnings (adjusted for inflation) into account. As a result, those working to a traditional age of 65 or 67 might be losing ten or more years of earnings history when the higher income years replace lower earning years from early in their career.
Consider the case of a person earning an inflation-adjusted $45,000 per year the first ten years of their career then working another 35 years making $55,000+ per year. For SS calculations, they will only end up with 35 years of earnings at $55,000+ per year and the $45,000 per year earned for ten years won’t matter at all in spite of paying SS taxes for those ten years!
The advice to “keep working till you’re 67” completely ignores the fact that the earnings in your later years might not increase your Average Indexed Monthly Earnings by very much since you’ll be replacing some years of earnings instead of adding your new earnings on top of your first 35 years of earnings. In some professions with relatively flat earnings over a full career, you might be earning about the same (in real terms) right out of college and 40 years later.
Pharmacists, for example, don’t make a lot more later in their career compared to entry level salaries. Tacking on ten years of extra work might add just a couple hundred dollars to the Average Indexed Monthly Earnings. A pharmacist with a full 35 years or more in the workforce would likely be in the 15% payout bracket (above the second bend point), which means a couple hundred dollars added to the AIME equates to an extra $35 per month in benefits. Work ten more years as a pharmacist just to earn $35 more per month from SS? Somebody needs to check their meds if they think that’s a swell idea.
What this means for the early retiree
Let’s take a look at my actual earnings as reported by the Social Security Administration (you can access your online SS account here). They roughly match the salaries I reported in my now-viral Zero To Millionaire In 10 Years post and the wages I earned dating back to the early days of my near-minimum wage jobs during high school and the better paying jobs I had during undergrad and law school.
In addition to my annual earnings, this table also shows the inflation adjustment factors and my annual earnings adjusted for inflation.
To understand the inflation adjustments, take a look at the 1996 Average Wage Index Factor. It’s 1.794. This means the 1996 earnings are actually worth 79.4% more in today’s dollars. In my case, the $519 I earned in 1996 is equivalent to $931 earned today. Adjust all my years of earnings to account for inflation, and it increases my total lifetime earnings from $616,783 to $707,497. That’s over $90,000 in increases due to inflation.
Out of the 19 years covered in the chart, I have earnings for 17 of those years. Since I have less than 35 years of earnings, every single year of my earnings will count toward my Average Indexed Monthly Earnings.
My total earnings adjusted for inflation are $707,497. Dividing by 420 gives me an Average Indexed Monthly Earnings of $1,685. Applying the Primary Insurance Amount formula gives me a monthly benefit of $1,036 at age 67 ( ($856 * 0.90) + ($829 * 0.32) = $1,036 ). On an annual basis, I will receive $12,432. Since Mrs. Root of Good has a similar earnings history, she’ll be entitled to roughly the same benefit. In total, our family will receive around $24,000 per year in Social Security benefits. That’s roughly two thirds of our $32,400 annual retirement budget!
As you can see, Social Security benefits can provide a subsistence level of income, or a generous supplement to other retirement income, even for an early retiree that works at a full time job less than 15 years.
Some claim Social Security will change over the next three decades before I can start drawing benefits. I predict any changes will be marginal. My benefit might not be quite as high or I might have to wait till age 68 or 70 to collect full benefits. If you disagree, let’s check back in with each other in 32 years and see how things turned out.
Now that I’ve determined I’ll get around $1,036 per month in SS benefits, let’s do some experiments.
What if I work another ten years at roughly my old salary of $70,000 per year (in today’s dollars)? That would double my lifetime earnings to about $1,400,000. Dividing by 420 gives me an AIME of $3,333. After applying the Primary Insurance Amount formula, I would be entitled to a benefit of $1,563 per month at full retirement age. That’s nothing to sneeze at. At age 67 I would get an extra $527 income per month with annual cost of living adjustments for the rest of my life. Not exactly life-changing, but if Mrs. Root of Good and I both put in ten more years, our SS would cover our entire retirement budget.
But I would have to work ten more years. Just to get $527 of additional income from SS. 32 years from now.
No thanks. I think I’ll stay early retired.
Taking this experiment even further, what if I worked until age 67 and ended up with at more than 35 years of earnings of $70,000 per year (assuming I never received more than inflationary raises, which is a believable scenario if I stayed in my old job with the State)? My monthly benefit would go up to $2,248 per month.
That would be 34 additional years of work and all I would get is slightly more than double the benefit I qualify for right now. Again, no thanks. It would be pure insanity to work another 34 years just to double my SS benefit.
If I did want more income for retirement, I’d focus on working and saving more in my investment portfolio until I hit my new target and not rely on working longer to get a higher Social Security benefit.
When does it make sense to work longer just to get more Social Security?
In general, it doesn’t make sense to work longer just to qualify for a higher Social Security payment. However, there are two cases where it might be worthwhile to work a little longer for SS benefits.
The first situation is if you don’t have the minimum number of credits (or quarters) to be eligible to collect Social Security. You need 40 credits to draw SS benefits. You can earn up to four credits per year, which means you can acquire 40 credits in as little as ten years. In 2016 it takes $1,260 of income to earn one credit (up to four credits maximum per year). In other words, it doesn’t take a lot of income to earn four credits per year.
For some extremely early retirees that might not have worked for a full ten years, it makes sense to have at least a little earned income throughout the rest of their lives so that they qualify for Social Security, even if the benefit is modest. Another huge benefit of earning 40 credits is that you will qualify for free Medicare Part A coverage at age 65 (which would otherwise cost $400+ per month). Regular income from a part time job would work, as would 1099 income from freelancing (you pay your own self employment taxes in the latter case).
Even if you don’t have the 40 credits, it might not matter since you can qualify on a spouse’s (or ex-spouse’s) record if they have the required 40 credits.
The other situation where it makes sense to work longer for SS benefits is the case of a low income earner that retires early. This hypothetical person would likely be an extremely early retiree living on a modest budget.
Jumping back to the “What are bend points?” section, recall that the Primary Insurance Amount formula is very progressive in nature. In the lowest earnings bracket, you get 90% of your earnings back in the form of a benefit increase. Go above the first bend point and your payout rate drops to 32% for every extra dollar. To be in the Social Security sweet spot, make sure your lifetime earnings take up all that space below the first bend point in the 90% payout territory.
By back-calculating things a bit, the lifetime earnings to max out that 90% payout space is $359,520 (for 2016). This could be $35,952 of earnings per year for ten years or roughly $72,000 for five years or around $18,000 for 20 years. If you haven’t earned at least that much, then you could work more and significantly increase your SS benefit.
What have we learned?
Let’s face it. Most of you didn’t read this whole article. Heck, I barely read the whole thing and I wrote it! So hopefully you’ll at least read this part where I recap the key lessons of Social Security for those retiring early.
- Social Security is a progressive social insurance program. You can work very little and still receive a benefit. Working at a high salary for many years won’t give you a proportional increase in benefits compared to the SS taxes you pay into the system.
- It doesn’t matter whether you earn a little bit for 35 years or a lot over a much shorter period of time. The SS benefits formula takes the highest 35 inflation-adjusted years of earnings and adds them up to determine your benefit.
- Working longer than 35 years might not increase your benefit at all. And if it does increase your benefit, the increase might be small since additional years of working beyond 35 start “erasing” lower earning years in your work history.
- If you haven’t worked at least ten years before retiring, you might not be eligible for SS benefits, so consider working a little bit to earn enough credits to qualify for SS (and Medicare).
- If you retired extremely early or earned very little during your lifetime, you might not be in the SS Sweet Spot. Make sure your lifetime earnings put you near the first bend point (about $360,000 total for 2016).
- When random strangers tell you to work a few extra decades just so you can increase your SS benefits by a modest amount, ignore them. They most likely don’t know about bend points, AIME, PIA, or really anything about how SS benefits are calculated.
For our own early retirement financial planning, we don’t have to get anything from SS to enjoy a successful retirement, but we expect it will be there in some form or another.
Did you learn anything new about Social Security today? How do SS benefits factor into your retirement planning?
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