To many Americans it’s a mystery of how their Social Security is calculated, and rightly so. However, it is not that complicated.
Social Security determines your average indexed (inflation-adjusted) monthly income, or AIME by applying its average wage index to your income history and then calculating the average monthly income based on your 35 highest-earning years. They include zeros for any of your 35 years without income.
Such indexation ensures that a worker’s future benefits reflect the general rise in the standard of living that occurred during his or her working lifetime. This is necessary because 35 years of earnings are used whereas a typical pension plan will use a five year average + or -.
Once the average earnings are determined the SSA multiplies your AIME by fixed percentages at three different income levels called “bend points.” Think of this as the benefit formula.
For example, if you’re first eligible for retiree benefits in 2021, you’d receive 90% of your AIME up to $996, 32% of your AIME between $997 and $6,002, and 15% of your AIME for anything above $6,002. The resulting figure is your primary insurance amount, or PIA. Your monthly benefit at full retirement age based on you date of birth.
As you can see, the lower income beneficiary receives a higher income replacement because more of their earnings have the higher 90 or 32 percentages applied. At the same time they are paying less in taxes because of their lower income while higher paid workers pay more in taxes and received a lower return when their benefit is calculated.