U.S. News Guide to Calculating Social Security Benefits Highlights Problems in Program

U.S. News & World Report's Philip Moeller has a three-part guide to how your Social Security retirement benefits are calculated. You can start reading the first part here. It's a very good piece of work, with far more detail on the actual benefit calculation than any other article I've ever seen. Moeller's done a good job here.

That said, I'd pretty much defy anyone reading the article to actually calculate their own benefit, even assuming they have full records of their earnings history. Check out this section, which as far as I can tell is entirely accurate, to understand why:

For people with enough earnings to qualify, Social Security then takes the average of their 35 highest years of wage earnings. But it doesn't just take the actual amount of money earned each year, Goss explained. It engages in extensive calculations to equalize the value of wages over time. Given the long-term effect of inflation, for example, $10,000 earned in 1980 is worth a lot more than $10,000 earned in 2009.

The equalization process involves looking at every IRS W-2 and, for self-employment earnings, Form 1099, that is filed by taxpayers each year. I always thought my W-2s were only of interest to the IRS but Goss says those records are actually processed for the IRS by Social Security. "We get all the W-2s and we process them, and we add up all your wages," he says. "We do that for everybody in the country who has wages reported. We look at the total amount of wages and the total number of people reporting wages." Dividing the two numbers produces a national average wage for each year, and tracking the changes of that number over time produces a national average wage index.

Going back to our example of wages earned in 1980, Social Security would look at the ratio of the average national wage in 2009 and the national average wage in 1980 and adjust the value of what you earned in 1980 up to 2009 levels. It then would take the 35 highest annual adjusted earnings years and calculate an average.

Up until people reach the age of 60, this 35-year average is adjusted each year to reflect inflation and changing national wage levels. In the year in which you turn 60, Social Security stops indexing your wages. Here's why. People can elect to begin receiving Social Security benefits as early as the age of 62, Goss explained. There's a two-year lag between when people report wage earnings on their W-2s and when the national wage index is calculated. The 2009 index, for example, is announced in late 2008, and is based on W-2s for 2007 earnings. So, in order for the agency to calculate the benefits of someone reaching the age of 62 in 2009, its latest wage information is based on how much money the person earned through 2007, when they turned 60.

Many people, of course, continue to work after they are 60 years old. Their wages for those years are not adjusted for inflation, and are compared with the wage-adjusted years to determine the top 35 years. This process continues until the year in which a person elects to begin receiving benefits. Once that happens, the 35 highest earnings years are averaged, the result is divided again by 12, and the agency determines a person's average indexed monthly earnings. This is a key figure, Goss said, and "becomes in effect your long-term career earnings level."

This passage – and it's only one part of the benefit formula – underlies my point in "Answer Quickly: How Much Do You Think You'll Get from Social Security?" that the program is just too complicated to serve effectively as the base of retirement income. That base should be something you can easily understand and predict, but the evidence indicates that even people on the verge of retirement have a very hard time predicting their Social Security benefit, even given the national distribution of the Social Security Statement. This complexity also results in people with the same lifetime earnings and contributions to the system getting very different retirement benefits, as I showed in "Will Your Social Insurance Pay Off?"

One problem I have with most potential Social Security reforms is that they make the system more complex rather than less so. Once policy people have mastered the ins and outs of the benefit formula, which takes a while, it seems the temptation to exploit that knowledge by generating even more ins and outs is too much to resist. But they should resist it.