I received a letter from a financial adviser the other day asking about a client who is still working at 63 years old, but who has significantly scaled back his work hours and earnings. She wondered what impact that might have on his future Social Security benefits. I'm sure other advisers have similar questions.
“His estimated benefits statement says that if he continues working until full retirement age, he will receive about $2,500 per month in benefits,” the adviser wrote to me in an e-mail. “But that assumes he will make full salary for the next three years, which he will not,” she wrote. “How can he arrive at a more accurate estimate of his benefits?”
His estimated benefits are close to this year's maximum retirement benefit of $2,642 per month for a worker retiring at age 66 in 2014. That suggests the client is a high earner. Remember, Social Security only counts earnings up to the taxable wage base each year. In 2014, the maximum earnings subject to the Social Security portion of the FICA payroll tax is $117,000. Earnings above that amount don't count in retirement benefit calculation.
“For high-income workers like your client, there probably will be little impact on his Social Security benefits even if he scales back his earnings in his early 60s,” I replied. “Even if he works part time in his final years on the job, his current income probably will still replace earlier lower-earning years when he was flipping burgers or delivering newspapers,” I wrote.
On the other hand, a client with fewer than 35 years of earnings could increase his or her retirement benefits by working a few extra years, replacing any “zero” years in the benefit calculation.
Your client can use Social Security's online retirement estimator to project his retirement benefits. Due to privacy restrictions, you can't do this for him, but you could use the calculator together with him in your office if he agrees. The estimator will let him create “what if” scenarios. For example, he can change his stop work dates or expected future earnings to create and compare different retirement options. But it does not provide annual earnings records.
Social Security benefits are based on your top 35 years of earnings. Your actual earnings are indexed to account for changes in average wages since the year the earnings were received. Any earnings received after age 62 are recorded at face value.
If you're really ambitious, you could take your client's actual earnings listed on his benefits statement and calculate his future benefit by applying the indexing factors for the year he turns 62. A separate index factor is applied to each year of earnings.
Social Security selects those years with the highest indexed earnings — including those earned after age 62 — Those are calculated with an index factor of one. (A year with no earnings is recorded as zero.) It adds those indexed earnings and divides the total amount by 420 — the number of months in 35 years. The result is the worker's average indexed monthly earnings, or AIME.
The final step is to compute his primary insurance amount, or PIA, using the formula explained below.
An individual who first becomes eligible for retirement or disability insurance benefits in 2014, or who dies in 2014 before becoming eligible for benefits, will have a PIA calculated as the sum of 90% of the first $816 of his AIME, plus 32% of his AIME over $816 and through $4,917; plus 15% of his AIME over $4,917.
The percentages are fixed by law, but the dollar amounts in the formula change annually. These dollar amounts are called "bend points."
A person who had maximum taxable earnings in each year since age 22, and who reaches at age 62 in 2014, would have an AIME equal to $8,890, according to an example supplied by Social Security's Office of the Chief Actuary. Based on this AIME amount and the bend points $816 and $4,917, the PIA would equal $2,642.
If the worker in this example collected retirement benefits at the earliest eligible age of 62, he would receive a reduced benefit of $1,982 (75% of his PIA). If he postponed collecting benefits until 70, he would receive $3,487 — a 32% increase due to four years of delayed retirement credits.
You can see that the PIA formula is progressive, tilting 90% of the benefit formula in favor of lower-income workers. For higher earners, additional years of work late in a career might not matter that much. Even if later, higher-earning years replace earlier, lower-earning years, it is likely to affect only the final bend point that includes just 15% of average monthly earnings that exceed $4,917 in the benefit calculation.
(Questions about Social Security? Find the answers in my new ebook available at arjuna-design.com/MBFebook.)
(This story has been updated to correct the total number of months in 35 years to 420.)