The word “formula” might call to mind a mathematical equation, or maybe the stuff in baby bottles. But beyond the uncomfortable image of spittle on the shoulder, people usually tend to equate formulas with intricate flowcharts of numbers or mechanics for complicated machines — things outside the reach of “regular people.” For that reason, when it comes to Social Security reform, one of the trickiest areas to discuss is adjusting the benefit formula.

But just as a machine’s gears and cogs require polishing and repair, so too does America’s oldest retirement program. Understanding the mechanics of the benefit formula is the first step toward fixing it. In that vein, we seek to explore potential changes to the sometimes overwhelmingly complex nuances of the benefit formula. Enacting real reform in this area would reduce the cost of Social Security, modernize the program for a 21st-century workforce, and still maintain retirement security for America’s seniors.

Two Girls Named Aime and Pia

Imagine a high school home economics course where students are paired up and assigned to cook a meal for the entire class.

Two girls named Aime and Pia are paired together, and each has a unique talent to help accomplish their task. Aime is a great cook who religiously watches the Food Network and can easily whip up several dishes catered to different types of eaters. Pia is a decent cook but is more gifted in understanding her classmates’ needs particularly well. She can identify the correct portions, nutritional balances, and taste preferences for the entire home-ec class. In this scenario, Aime creates the right food and Pia distributes the meal appropriately for each student.

There’s a point to this story beyond just unusual names — the two girls in home-ec correspond to the main factors in the Social Security benefit formula. AIME stands for the Average Indexed Monthly Earnings, which roughly equates to how much money a person makes per month over the course of his or her working career. PIA is the Primary Insurance Amount and tells us the actual dollar benefit for every social security recipient based on his or her AIME score. Similar to the cooking class scenario, AIME establishes a pool of dollars for each individual, and the PIA calculates how much of that pool will end up as a benefit.

The Benefit Formula in a Nutshell

A person’s AIME is determined by averaging the highest-earning 35 years of their work life. The number is then divided by 12 in order to show the monthly average earnings.  The average is then indexed, or updated, based on the current national average wage. This calculation allows a person’s work earnings from the 1970’s to have the same wage power as a worker today. The AIME for any given individual, then, will come to a monthly dollar amount that reflects earnings over the course of a person’s career.

The PIA takes the raw AIME score and applies bend points and bend point factors to determine a person’s actual monthly benefit. A bend point is a fixed dollar amount that the Social Security Administration sets every year. There are only two bend points, and they that act as thresholds that separate a person’s AIME score into three sections.

In 2018, the first bend point is $895, and the second point is $5,397. The Social Security benefit formula applies a specific bend point factor for each of the three sections. The bend point factors are 90, 32, and 15. For example, if an individual’s AIME is $6,000 then the first $895 would be multiplied by 90 percent. The AIME amount between the bend points of $895 and $5,397 are then multiplied by 32 percent. Any amount over $5,397 is multiplied by 15 percent. The sum of all three sections would equal a PIA of $2,337 per month for that individual.

The benefit formula is simply a way of calculating a person’s monthly benefit by adding up all three sections after the bend point factors have been applied. The formula operates in this fashion to make benefits progressive. This means that low-wage workers will receive a higher benefit relative to what they made while working than a higher-earning individual. For instance:

  • A low wage worker with a $500 AIME will be able to retain 90 percent of their working wages in retirement which comes to a PIA of $450.
  • A higher wage worker with a $10,000 AIME also keeps 90 percent of their first $895. But that earner only retains 32 percent of every dollar above the first bend point and only 15 percent of earnings after the second.  The PIA for this worker is $2,637.

The formula is progressive because while the higher wage earner will receive a larger monthly paycheck, their PIA replaces only 40 percent of what they made per month while working. In contrast, the lower-wage worker recovers 90 percent of what they were earning while working which will allow them to rely on Social Security to continue their quality of life in retirement.

Polishing the Gears

The Social Security debate is often fierce, with passionate people on both sides. Proponents of change understand that the program can no longer pay out what it promises and must borrow to fulfill its obligations. Mounting debt and the looming bankruptcy of our nation’s oldest security program are enough to demand adjustments. Opponents of reform argue that any changes to social security benefits will amount to a cut in someone’s retirement paycheck — someone will see benefits fall; someone will suffer. And it’s true that adjustments to the formula will reduce a person’s monthly benefit compared to what they would have received.

But think of the social security program as a machine with numerous pieces working together. If over the course of seventy years, we opened the machine to find rusted gears, brittle cogs, crusted winches, and fading contraptions, wouldn’t we want to fix it? Adjusting social security’s benefit formula is akin to polishing and repairing the inner-workings of a machine so it can work better. While there might be some pain in the short-term, political and otherwise, it is worthwhile to seek the type of changes that are necessary if we want the program to keep functioning in the first place for very much longer.

By incorporating smart, responsible formula reform, any perceived “cut” will actually be the result of aligning social security with modern work life. It’s possible to continue living with a broken machine until it finally crashes, but it will be far better, in the long run, to invest in new parts and repairs. Benefits will be adjusted downward for a time, but these minor reductions can play a large part in fixing the programs’ finances and securing retirement income for the oldest Americans. The following sections outline potential modifications to the benefit formula in more detail.

Adjustment #1: Increase Work Years

Remember, the AIME formula starts by averaging the highest 35 years of work. One reform option is to increase the number of years calculated. Thanks to advanced medical care and increased life expectancy, as well as the availability of work in non-physical labor, Americans are extending their working years.

According to the Center for Retirement Research at Boston College, retirement ages for both men and women have increased by two years since the 1990’s. In the modern economy, it is not uncommon to find individuals working far past the retirement ages of years past. By increasing the amount of years calculated for the AIME, a more accurate picture of an individual’s career can be captured.

Several proposals call for raising the amount of years calculated to 38 or even 40 years. Such a change would yield a better representation of a person’s earnings over time, and therefore provide benefits that match a more accurate average. However, this reform could reduce a person’s benefits because it adds fewer high-earning years to the calculation thereby lowering the AIME score.

Adjustment #2: Price Indexing

One of the most complex options for adjusting the benefit formula is switching from wage indexing to price indexing. In brief, because the wages a person earns over their lifetime rise faster than average prices, any updates to the formula that swaps wages for prices will mean that benefits increase at a slower rate.

Think of two friends going for a run. One friend is an experienced runner who tracks a faster time than their friend. Because the quicker runner always gets ahead, the slower runner invites a third friend to run with her. The third runner, however, has a choice and can either stick with their friend or keep pace with the faster runner. In this scenario, the faster runner is “wage growth,” the slower runner is “price growth,” and the third runner is “social security benefits.” Whoever the third runner decides to track with will determine how fast they run. This is the basic principle behind switching to prices instead of wages when calculating social security benefits.

Numerous proposals have included price indexing at various points within the benefit formula, which currently uses wage indexing at each level. Price indexing has the effect of slowing the growth in benefits, but this can be accomplished in several ways:

  • Price Index the AIME

When updating a person’s average wages for the AIME based on current wages, the update would actually be based on the rise in average prices. This would reduce the initial benefit.

  • Price Index the Bend Points

The two bend points in the benefit formula increase each year based on average wages, but if they were price indexed, the thresholds would rise much slower than under the current system. The result would be to push nearly everyone’s AIME higher, meaning that most of their PIA would be based on the 32 and 15-percent factors.

  • Price Index the Bend Point Factors

If the 90, 32, and 15-percent factors were price indexed, then all benefits would be reduced equally. Wage indexing maintains the three factors at their constant rates, but a change to prices could lower the factors to 88, 30, and 13 for example. If the AIME scores and bend points were still indexed at wages, then price indexing for the factors means lower PIA’s.

A final note of this adjustment option is the possibility to use progressive price indexing. This method would keep wage indexing for lower income earners, but institute a form of price indexing for higher earners. Usually, the lowest 30 percent of earners would be protected by a “shield” from price indexing, but that percentage can go higher to almost 70 percent of retirees in some proposals. This form of price indexing is seen to be more equitable because it keeps the current benefits for poorer retirees and reduces them for higher income Americans.

Adjustment #3: Reduce the Factors

Similar to the price indexing methods above, some benefit formula adjustments call for a straightforward cut in the bend point factors. The central idea is to reduce PIA’s for higher earners by decreasing the 32 and 15 percent factors. Some options include reducing just the top or the top two factors by one-third in order to trim the monthly benefit paid out to higher earners. However, proposals exist to cut all three factors by an equal amount and maintain all current formula operations (i.e a 10 point cut yields an 80, 22, and 5 percent factors). Under an “equal cuts” scenario, every beneficiary would see a lower PIA.

Another option is to continuously reduce the factors over time until a target set of percentages has been reached. This method would phase in the lower PIA’s over time, which makes the reductions less drastic when seniors plan for retirement.

Adjustment #4: Cost of Living Change

Another way to improve accuracy in the benefit formula is to change how we compensate for the cost of living increases. Therefore, the benefit formula contains an automatic update to all benefits to ensure retirees can afford to live in an advancing and more expensive world.

Every year after a person receives their initial social security benefit they are entitled to, in effect, a raise called a cost of living adjustment (COLA). The COLA is a mechanism that bumps up the value of every senior’s benefit based on the inflation growth of the average price growth in the economy. The consumer price index (CPI) is the main tool that calculates annual COLA increases.

CPI takes a sample “basket of goods” that U.S consumers purchase, and compares the price of that basket from year to year. The COLA uses that percentage change to determine the benefit increase that will maintain the cost of living for beneficiaries. The current CPI used to calculate the COLA is the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). The CPI-W uses a formula based on the spending habits of 32% of the population and is not regarded as an accurate measure of inflation.

The fourth adjustment option considers moving to a Chained Consumer Price Index for All Urban Consumers (C-CPI-U) that captures the spending habits of 87% of the population, and its formula is considered to be more accurate when adjusting benefits for inflation.

The C-CPI-U would slow COLA increases by .3% a year when compared to the CPI-W. According to the Simpson-Bowles Commission, a C-CPI-U could save $300 billion over ten years and much more later on.