Social Security Benefits and the Effect of Declines in Average Wages and Prices

Social Security Benefits and the Effect of Declines in Average Wages and Prices

July 13, 2020
Social Security Benefits and the Effect of Declines in Average
Wages and Prices
Recent news articles have highlighted how a decrease in
age 60 are indexed, the AIME is obtained by dividing the
national average wages may have a negative impact on the
total of the highest 35 years of indexed earnings by 420
Social Security benefits of individuals reaching age 60 in
(i.e., total months in 35 years).
2020. Social Security benefits are tied to a worker’s
earnings record but are also affected by changes in national
Next, the benefit formula process computes a worker’s
wages and prices. This InFocus explains elements of the
Primary Insurance Amount (PIA)—the basic monthly
benefit formula, discusses the possible effects of declining
benefit for a retired worker who begins to receive benefits
average wages and prices on benefits, and reviews policy
at the full retirement age (i.e., 67 for those born in 1960 and
options for Congress. Congressional interest may be high
later). Using two bend points, which are also adjusted
because of the large number of potential Social Security
annually for average wage growth in the economy, a
beneficiaries for whom these benefits would comprise a big
worker’s AIME is sectioned into three brackets of earnings.
share of their total income.
A fixed PIA factor—90%, 32%, and 15%, respectively—is
applied to each bracket of an AIME. The PIA factors are set
Average monthly Social Security benefits generally
in statute. The bend points are based on the year an
increase because of wage-indexing and price-indexing.
individual is first eligible for Social Security benefits (i.e.,
Initial benefit amounts (i.e., retired worker benefit amounts
age 62). However, given the lag time in computing the
that can be collected at the earliest eligibility age of 62) are
AWI, the value from two years prior is used to determine
indexed to the average wage index (AWI). Benefit amounts
the bend points (i.e., when the worker was age 60). For
collected after the earliest eligibility age are indexed to the
example, in 2010, the bend points were $761 and $4,586. In
Consumer Price Index for Urban Wage Earners and Clerical
2011, due to a decrease in the AWI in 2009, the bend points
Workers (CPI-W) through an annual cost-of-living-
decreased to $749 and $4,517. This is a second area in
adjustment (COLA). Although wages and prices generally
which the AWI value during the year in which a worker
increase over time, instances may arise where wages,
turns 60 plays an important role in determining a worker’s
prices, or both decrease. Under such conditions, as may
benefit amount. Benefits paid after age 62 are increased
result from Coronavirus Disease 2019 (COVID-19)
annually by a COLA based on changes in the CPI-W.
circumstances, benefit amounts would be affected.
Effects of Wage Indexing
Social Security Benefit Formula
To compute the AIME, earnings are indexed to growth in
Workers become eligible for Social Security benefits by
the AWI. Bend points used to compute the PIA are also
working in covered employment, generally requiring about
indexed by growth in the AWI. Thus, from year-to-year,
10 years of work, and are first eligible for Social Security
average benefits for new beneficiaries increase at
retirement benefits at age 62. To determine benefits, the
approximately the same rate as average wages in the
same process is used for all beneficiaries . Lifetime earnings
economy. This has generally resulted in stable replacement
are wage-indexed to account for growth in economy-wide
rates—the portion of a worker’s career-averaged earnings
earnings over a worker’s career. Depending on the year of
that Social Security benefits replace.
birth (i.e., birth cohort), two workers with identical earnings
profiles may have different wage-indexed amounts.
Over its history, the AWI has increased in all but one year
(2009), at an average annual rate of 4.5%. All else being
The benefit formula process first determines a worker’s
equal, initial benefits generally increase over time.
Average Indexed Monthly Earnings (AIME). The AIME
However, under the current-law benefit formula, a decrease
computation updates a worker’s past earnings to account for
in the AWI in the year a worker turns 60 would result in a
growth in overall economy-wide earnings. This is done by
lower AIME than if the wage growth were to increase or
indexing each year of a worker’s taxable earnings by the
remain level. The same is true for the bend points used in
growth in the AWI. Given lag time in computing the AWI,
the PIA calculation. That is, those turning age 60 during a
earnings up to age 60 are wage-indexed, whereas earnings
year in which there was a decrease in the AWI would
from later years—at ages 60 and above—are not. For
receive a lower PIA than if wages were to follow the
example, the Social Security average wage grew by 29.6%
generally positive trend. For example, consider a
between 2000 and 2010 (from $32,155 to $41,674). As a
hypothetical median earner who earned at the median AWI
result, a worker who turned 60 in 2010 and earned $20,000
level for each year of employment and turned 60 in 2013.
in 2000 would have wage-indexed earnings of $25,921
Such a worker would have an AIME of $3,749.47 and a
($20,000*1.296) for 2000. As such, growth in the AWI
PIA of $1,658.60. Assuming an arbitrary decrease of 5% in
during the year in which a worker turns 60 is an important
the AWI for that year, the same worker would have an
part of the benefit calculation. Once annual earnings before
AIME of $3,576.00 and a PIA of $1,579.80. Before COLA
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Social Security Benefits and the Effect of Declines in Average Wages and Prices
or other possible adjustments, this would be a benefit
Because no COLA was payable in January 2016, the CBB
decrease of $945.60 per year.
remained unchanged.
If the AWI decreases in a given year and then resumes
One additional relationship is notable with respect to the
typical growth in later years, a young worker (i.e. under age
Social Security COLA. In years when there is no Social
60) with earnings in that year would experience slightly
Security COLA or a very low COLA, for Social Security
higher future benefits than if the AWI had increased
beneficiaries who have their Medicare Part B premiums
consistently or remained level. A worker’s earnings from
withheld from their Social Security benefit, a hold-harmless
the year in which the AWI had decreased would yield
provision in the Social Security Act ensures that their net
relatively higher indexed earnings for that year, thus a
benefits will not decrease as a result of an increase in the
higher AIME. Consider the earlier example of a worker
Medicare Part B premium. For example, nearly 70% of
who earned $20,000 in 2000. If the AWI had decreased by
Medicare beneficiaries were protected by the hold-harmless
5% in 2000 (from $32,155 to $30,547), the indexed value
provision in 2016 and 2017 when the Social Security
of those earnings in 2010 would grow 5.3%, from the
COLAs were 0% and 0.3%, respectively.
earlier $25,921 to $27,285 ($20,000 x [$41,674/$30,547]).
“Notch Effect” and Birth Cohorts
Declining wages will not only affect old-age benefits for
Effects of wage indexing, price indexing, or both can result
retired workers. All benefit calculations (e.g., for disabled
in what is commonly referred to as a notch effect. A notch
workers or family members of a retired worker) that are
occurs when one cohort of beneficiaries receives a different
indexed during a year of declining wage growth would be
level of benefits (i.e., replacement rate) compared to an age-
affected in a similar manner.
adjacent cohort (in the 1970s notches arose from changes in
the benefit formula). The existence of a notch can lead one
Increases in other Social Security program elements are tied
cohort to be perceived as receiving inflated benefits, while
to the increase in national average wages. These program
an age-adjacent cohort would be perceived as receiving
elements include the amount of earnings needed for a
deflated benefits. That is, because of birth year and
Social Security quarter of coverage (i.e., an earnings
indexing, a worker may receive a lower replacement rate of
credit); the monthly substantial gainful activity (SGA)
his or her earnings relative to a similar worker who is one
threshold for nonblind Social Security disability
year older or younger. Also, lower initial benefits would be
beneficiaries; and the annual coverage thresholds for
compounded as it would result in a nominally lower COLA
domestic workers and election workers.
every year. Some expect the AWI to decrease in 2020 and
argue those born in 1960 (i.e., turning 60 in 2020) will
Effects of Price Indexing
likely experience a notch effect as a result of COVID-19.
After a beneficiary’s first year of eligibility, subsequent
benefits are adjusted for price growth. The annual COLA is
What Can Be Done?
based on changes in the CPI-W, updated monthly by the
Policymakers have several legislative options to choose
Bureau of Labor Statistics. For Social Security, the COLA
from in addressing possible notch effects. One option is to
equals the change in the CPI-W from the third quarter of
do nothing, as was done in 2009. Alternatively, Congress
the prior year to the third quarter of the current year. The
could administer ad hoc benefit increases to birth cohorts
COLA announced in October becomes effective in
that have been adversely affected by changes in wage or
December of the current year and is payable in January of
price growth, effectively “resetting” a cohort’s lifetime
the following year; Social Security payments always reflect
benefit levels. In terms of wage indexing for those born in
the benefits due for the preceding month.
1960, some have suggested using wage data only from the
first quarter of 2020 (pre-COVID-19).
In most years, prices increase, resulting in a positive COLA
being applied to the next year’s benefits. However, if there
Policymakers could opt for a permanent solution that would
is no percentage increase in the CPI-W, no COLA is
prevent future notches from occurring. One solution that
payable, and Social Security benefits are not adjusted. No
would address possible effects of negative wage growth
COLA was payable in January 2010, January 2011, or in
would be to prevent the AWI from decreasing (i.e., the
January 2016. Section 215(i) of the Social Security Act
AWI in one year could not be determined to be less than the
protects Social Security benefits from being decreased
AWI in the preceding year). In the 116th Congress, such a
during periods of negative price growth.
proposal was introduced by Senators Tim Kaine and Bill
Cassidy (S. 4180). A different approach could be to require
Several Social Security program elements are indexed to
the use of any prior year’s AWI if it exceeds the current
wages rather than prices but may increase only when a
year’s AWI in the calculation of a worker’s AIME and for
COLA is payable. These program elements include the
indexing the bend points used to calculate the PIA. Such a
contributions and benefits base (CBB, or the maximum
provision, among other things, was included in a bill
earnings subject to payroll tax); the retirement earnings test
introduced by Representative John Larson (H.R. 7499).
exempt amounts; and the SGA threshold for blind Social
Security beneficiaries. In years in which no COLA is
Barry F. Huston, Analyst in Social Policy
payable, the value of these program elements is unchanged.
Paul S. Davies, Specialist in Income Security
For example, had a COLA been payable for Social Security
benefits due in January 2016, the CBB would have
IF11599
increased from $118,500 in 2015 to $122,700 in 2016.
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Social Security Benefits and the Effect of Declines in Average Wages and Pric es

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