Calculation of Lifetime Average Earnings

Background

Social Security benefits are calculated as a percentage of lifetime average earnings. Policymakers consider two factors when establishing the calculation of lifetime average earnings. They decide how many years to average together and how to adjust past earnings to current levels.

The Social Security benefit formula averages the worker’s highest 35 years of earnings to form the base of a Social Security benefit. Increasing the number of years used to calculate average earnings would negatively affect some groups of workers. Those who have experienced long spells of unemployment, or otherwise spent time out of the labor force, would have lower averages. For example, women are much less likely than men to have 35 years of earnings. They are more likely than men to take time out of the labor force for caregiving responsibilities. As a result, they have years without income among their top 35 earnings years. This substantially brings down their lifetime average. Increasing the number of years in the formula would exacerbate this result.

The calculation of average lifetime earnings also requires policymakers to decide how to adjust each year of earnings to make them comparable. For example, a $20,000 salary could buy a lot more 30 years ago than it can now. The calculation of average lifetime earnings to determine benefits must take this into account. The result of these calculations is each worker's average indexed monthly earnings and serves as the basis for benefit calculations.

Previous earnings can be adjusted in one of two ways: based on how either wages or prices have changed over time. Social Security currently uses wage indexingTo make the value of something rise or fall according to changes in an indicator such as inflation.. Historically, average wage increases in the economy have exceeded price increases by about one percentage point per year over long periods of time. As a result, changing from wage indexingTo make the value of something rise or fall according to changes in an indicator such as inflation. to price indexingTo make the value of something rise or fall according to changes in an indicator such as inflation. of past earnings would lower benefits and therefore lower Social Security costs.

Wage indexingTo make the value of something rise or fall according to changes in an indicator such as inflation. ensures that the worker’s benefits in retirement reflect productivity increases during his or her working life, as well as standard of living improvements. Using prices to index a worker’s wages gives less value to wages earned early in a career and would reduce replacement rates and lifetime benefits for all workers.

Other parameters, such as the thresholds used in the benefit calculation formula, also need to be wage-indexed each year.

CALCULATION OF LIFETIME AVERAGE EARNINGS: Policy

CALCULATION OF LIFETIME AVERAGE EARNINGS: Policy

Number of years

The number of years used to calculate benefits should not be increased beyond the 35 years designated in current law.

Indexing

Policymakers should retain wage indexingTo make the value of something rise or fall according to changes in an indicator such as inflation. of both the average indexed monthly earnings and the thresholds used in the formula for the Primary Insurance AmountThe basis for determining Social Security benefits, calculated by applying a benefit formula to a persons average indexed monthly earnings..