Calculation of Lifetime Average Earnings

Background

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

Currently, 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 groups of workers who tend to experience long spells of unemployment or otherwise spend time out of the labor force. 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 “zeroes” among their top 35 earnings years, substantially bringing 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. Over the decades of a person’s career, price levels tend to rise. A $5,000 salary could buy a lot more 30 years ago than it can now.

Two ways to adjust previous earnings are based on how wages have changed over time (wage indexing) or how prices have changed over time (price indexing). Social Security currently uses wage indexing. Historically, over long periods of time such as a person’s working life, average wage increases in the economy have exceeded increases in prices by about one percentage point per year. As a result, changing from wage indexing to price indexing of past earnings would lower benefits and therefore lower Social Security costs.

Wage indexing 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.

 

CALCULATION OF LIFETIME AVERAGE EARNINGS: Policy

Number of years

In this policy: Federal

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

Indexing

In this policy: Federal

Policymakers should retain wage indexing of both the Average Indexed Monthly Earnings and the bend points used in the formula for the Primary Insurance Amount.