Financial advisors may be overestimating their clients' Social Security benefits if they are not aware of two laws that can reduce benefits.
The Estimate of Benefits report, which is the baseline most planners use to project Social Security benefits in retirement, has several important embedded assumptions that can affect what any given worker will actually receive. For example, the amount shown on the report at various retirement dates assumes the worker will continue working at the same covered income from now until that retirement date. Should the worker leave the labor force, or work at a higher or lower wage before collecting benefits, the estimate could be off.
Windfall Elimination Provision
Social Security benefits are based on your Average Indexed Monthly Earnings, which is calculated by averaging your highest 35 years of earnings up to age 60, indexing them for inflation, and dividing by 12.
As discussed in the publication, Windfall Elimination Provision, available on the Social Security Administration's website, AIME is split into three tiers, each of which receives a different factor. The tiered approach allows lower wage earners to have a higher percentage of their income replaced by Social Security; higher wage earners see a lower percentage of their total income replaced. The first tier captures up to $885 in monthly earnings and is multiplied by 90 percent. The second tier captures from $885 to $5,336 in monthly earnings and is multiplied by 32 percent. The third tier captures the balance of any monthly earnings above $5,336 and is multiplied by 15 percent. Together, this becomes your Primary Insurance Amount, which is your benefit at full retirement age. On average, the Social Security Administration estimates that it will replace 40 percent of wages for most workers.
Prior to 1983, workers whose primary job was not covered by Social Security would show AIME similar to very low wage workers because they would have many years of $0 in eligible earnings averaged into their years of covered employment. As a result, these workers received a higher percentage of their income replaced by Social Security, on top of a private pension. To rectify this, beginning in 1983, the formula was changed for workers with noncovered employment. The 90 percent factor applied to the first tier was reduced, and this change was phased in for workers turning age 62 (or becoming disabled) between 1986 and 1989. For workers reaching age 62 (or becoming disabled) after 1990, the 90% factor could be reduced to as little as 40%. By doing the math, you can see that the Windfall Elimination Provision can reduce Social Security benefits significantly. As a protection for smaller private pensions, there is an overall reduction cap of 50%, meaning that workers cannot lose more than half of their own Social Security benefits for noncovered earnings, regardless of the size of the private pension earned by the worker.
There are some exceptions to this reduction, the most important for advisers being cases where 30 years of substantial earnings are covered by Social Security. The Social Security Administration offers two online WEP calculators. Each requires entering the amount of any private, noncovered pensions.
The first calculator estimates the WEP reduction based on estimated earnings covered by Social Security. It requires manually entering earnings for each year of covered employment. The second calculator, a new version of which was just released in August 2017, incorporates actual earnings records from the Social Security Administration. The calculators allow users to determine whether they meet the 30 years covered earnings test, as well as the substantial earnings test.
Note: The WEP reduction will not affect spousal or survivor benefits.
Government Pension Offset
Dependent benefits, a program that started with the advent of Social Security in the 1930s, are paid to spouses and survivors. Originally, dependent spousal benefits were designed to provide a benefit to nonworking homemakers. Today, in cases where both partners in a marriage have covered employment, the benefit of the earner claiming spousal benefits will be the larger of their own benefit or the dependent benefit, but not both. In other words, their spousal benefit would be limited if they were also entitled to their own benefit from covered employment.