The Social Security Administration uses the Average Wage Index (AWI) as the foundation in calculating a person’s Social Security benefit payments. Using this wage data helps ensure that benefit payments reflect the general rise in the standard of living that occurred during an individual’s working lifetime.
The system hasn’t always been linked to changes in wage data. Prior to the 1972 Social Security Amendments, changes to the various components of the benefit program were determined by Congressional action. The 1972 amendments introduced the concept of automatic adjustments based on the changes to the cost of living. Under these rules, if inflation went up, so would benefits.
By 1973, the Social Security Board of Trustees began to project financial problems for the system and recognized that the 1972 amendments were too short-sighted in their approach to automatic increases. There were a number of factors that were of concern, but the most immediate was the issue caused by the combination of soaring inflation and stagnant wage growth.
Individuals saw their projections of Social Security benefits increase beyond what they made while working because payments were tied to inflation. The 1977 amendments were enacted as a fix for this issue and the general solvency of the system, with the most significant change coming from the complete overhaul of the Social Security Administration’s benefits calculation.
For individuals eligible for Social Security benefits after 1978, their payments were determined by a formula tied to the wage index instead of the consumer price index. The was referred to as “decoupling,” and was meant to give a stable relationship between an individual’s Social Security benefit and their pre-retirement earnings.
To accomplish this, the Social Security Administration tied both the formula for determining initial benefits and the indexing of a person’s historical earnings to the average wage index.
What is the Average Wage Index (AWI)?
The Average Wage Index, or AWI, tracks the annual changes to the raw wages of Americans. These “raw wages” are defined by the Social Security Administration as compensation which is subject to Federal income taxes, as reported on Form W-2 by employers. It also includes contributions to deferred compensation plans, but excludes taxable distributions from retirement plans.
The final raw wages examine total aggregate wages divided by the number of workers.
The AWI also controls several pieces of the Social Security system that require annual recalculations, including:
- The earnings limit
- The maximum taxable wage base
- The maximum family benefit
- The amount needed to earn one credit
- The old law contribution and benefit base (used to determine minimum primary insurance amount and substantial earnings under theWindfall Elimination Provision)
- The coverage thresholds for domestic and election workers
- The amount of substantial gainful activity for disabled individuals
This explains why annual changes to the Average Wage Index are ultimately responsible for most of the annual changes we see to Social Security as a whole. It should also make it quite clear that it’s important not only to understand what the AWI is, but also what parts of the system it controls and how it impacts various calculations tied to benefits.
How is the Average Wage Index Calculated?
The AWI is calculated on an annual basis by applying the percentage of year-over-year change in the average raw wages to the average wage index.
For example, the raw wages in 2017 were $48,251.57. In 2018 they were $50,000.44. This was an increase of 3.62%.
That 3.62% increase was multiplied by the 2017 average wage index value of $50,321.89, which resulted in the 2018 average wage index of $52,145.80.
When changes occur, they’re not always represented by increases. In 2009, for example, the AWI saw a 1.51% decrease influenced by the financial crisis when employees accepted pay cuts to save their jobs (or worse: lost their job completely).
Although 2009 was the first time since the 1977 amendments that we saw the AWI decline it isn’t likely to be the last. We may see this in this year or the next, as Depression-era unemployment numbers caused by the global COVID-19 pandemic work their way through the system.
Where Do COLAs Fit In?
To avoid confusion, it makes sense to briefly mention the annual cost of living adjustments (or COLAs) that are applied to Social Security benefits. These increases are not based on changes to the average wage index. Instead, they’re based on the year over year changes in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).
For retirement benefits, the COLAs are applied to your benefit in the year you turn 63 and thereafter. You do receive the COLA for the year you turn 62; it just isn’t applied until the year you turn 63. Another way to frame this is by thinking of the AWI as taking care of the inflation before age 62, and the CPI-W taking care of the inflation at and after age 62.
The Average Wage Index in Action
So how is the AWI actually applied in the benefits calculation? There are two distinct steps in the process:
- Indexation of historical earnings to determine AIME (the benefits formula indexes all your historical earnings, up to the taxable maximum, through age 59; earnings at 60 or later are used at face value).
- Applying AIME to bend point formula to determine PIA
The AWI is used in both these steps. To calculate your indexing factors, you take the AWI in the year you attain age 60 and divide by the AWI in each of the other years you had earnings (but only up to the maximum earnings taxable for Social Security).
This will result in a ratio that’s commonly called the indexing factor. You simply multiply this indexing factor by each year’s actual earnings to result in that year’s indexed earnings.
Once your earnings are indexed to reflect wage inflation, you drop all earnings years except for the top 35. Then you take these 35 years, sum them, and divide the total by 420. The result of this calculation is known as your Average Indexed Monthly Earnings (AIME).
Now that you have your AIME, you’re ready to determine the heart of your benefit, or your primary insurance amount (PIA).
The PIA is simply the result of your benefit calculation and is generally your full retirement age benefit amount. This calculation uses the “bend point” formula that’s in effect for the year you attain age 62, or the year you become disabled or die before 62. These bend points are changed annually based on the changes in the average wage index (more on how to calculate that in a moment).
There are two numbers that make up this formula, which are separated into three separate bands (see chart below for illustrative example):
- For earnings that fall within the first band, you multiply by 90%. That is the first part of your benefit.
- For earnings that fall within the second band, you multiply by 32%. That is the second part of your benefit.
- For earnings that are greater than the maximum of the second band, you multiply by 15%. This is the third part of your benefit.
The sum of these three bands is your PIA or benefit amount at full retirement age.
How Are Bend Points Determined?
Because there is often a lag time in updating the average wage index, the bend point calculation always uses the AWI data from two years prior to the year you attain age 62. For example, if you turn 62 in 2020, the AWI data from 2018 will be used to determine the bend points used in your calculation.
To determine bendpoints, you’ll need to use this formula:
(Your Age 60 AWI / 1977 AWI) x $180 (1979 1st Bend Point) = 1st bend point
(Your Age 60 AWI / 1977 AWI) x $1,085 (1979 2nd Bend Point) = 2nd bend point
You can find examples of this calculation on the Social Security website.
The AWI’s Other Functions
The steps listed thus far on using the AWI for indexing your earnings and calculating bend points are only for initial benefit determination — but the Average Wage Index comes into play in many other crucial areas of Social Security.
Let’s briefly cover each of the other components controlled by the AWI, and examine how you can calculate those as well.
As you move through these calculations, it may be handy to have this link to refer to the Average Wage Index by year.
The Earnings Test
If you apply for retirement benefits before your full retirement age, there is an earnings limit that can reduce or eliminate your benefit if you exceed the thresholds for that year.
Because there is an earnings test for all the years before the year you attain full retirement age and an earnings test for the year you attain full retirement age, there are two separate, but very similar, calculations to determine each.
To obtain the earnings test for years before full retirement age, use this formula:
(AWI from 2 year ago / 1992 AWI) x $670 (1994 earnings test amount)
To obtain the earnings test in the year full retirement age is attained, use this formula:
(AWI from 2 year ago / 2000 AWI) x $2,500 (2002 earnings test amount)
If the result is not a multiple of $10, round it to the nearest multiple of $10. The annual exempt amount is then 12 times the rounded monthly exempt amount.
You can find examples of this calculation on the Social Security website. There are also two important notes to keep in mind here:
- The earnings test will only change in years where there is a cost of living adjustment.
- The earnings required for one credit cannot decrease. If the calculation reflects a decrease, the earnings test amounts will not change from one year to the next.
The Maximum Taxable Wage Base
There is a limit to the amount of earnings that are subject to Social Security taxes. This is referred to as the taxable maximum or the wage base.
To calculate the current year wage base, you can use the following formula:
(AWI from two years ago / 1992 AWI) x $60,600 (wage base in 1994)
The base will only change in years where there is a cost of living adjustment, and this amount cannot decrease. If the calculation reflects a decrease, the old-law base will not change from one year to the next.
If the amount calculated is not a multiple of $300, it is rounded to the nearest multiple of $300.
You can see the SSA example of this calculation on their website.
The Maximum Family Benefit
Your eligible family members could be eligible for payments from your Social Security if you die, become disabled, or retire. However, there is a limit to these payments that’s commonly referred to as the Maximum Family Benefit (FBMAX).
The formula used to compute the FBMAX is very similar to the bend point formula used to compute the Primary Insurance Amount. The exception in this case is you take your already computed PIA and apply it to a FBMAX bend point formula with three separate numbers forming four separate bands.
For the family of a worker who becomes age 62 or dies in 2020 before attaining age 62, those numbers are: $1,226, $1,770 and $2,309.
The 2020 FBMAX formula appears as follows:
(a) 150 percent of the first $1,226 of the worker’s PIA, plus
(b) 272 percent of the worker’s PIA over $1,226 through $1,770, plus
(c) 134 percent of the worker’s PIA over $1,770 through $2,309, plus
(d) 175 percent of the worker’s PIA over $2,309
To calculate these numbers, you’ll use the following formula:
(AWI from 2 year ago / 1977 AWI) x $230 (1979 first FBMAX bendpoint)
(AWI from 2 year ago / 1977 AWI) x $332 (1979 second FBMAX bendpoint)
(AWI from 2 year ago / 1977 AWI) x $433 (1979 third FBMAX bendpoint)
There is an example of this on the Social Security website.
Social Security Credits
Social Security credits are the building blocks that the Social Security Administration relies on to determine whether or not you qualify for one of its programs. In 2020, you receive one credit for each $1,410 of earnings, but you cannot receive more than four credits per year.
To calculate this number, the Social Security Administration uses the following formula:
(AWI from two years ago / 1976 AWI) x $250 (1978 earnings required for a credit)
The result should be rounded to the nearest multiple of $10.
The earnings required for one credit cannot decrease. If the calculation of the AWI reflects a decrease, the earnings test amounts will not change from one year to the next.
You can see an example of this calculation as well as a listing of yearly earnings required for one credit at the SSA’s website.
Old-Law Contribution And Benefit Base
The Old-Law Contribution and Benefit Base is the maximum taxable earnings base that would have been effective without the enactment of the 1977 amendments to the Social Security Act.
Although this is a fairly obscure part of the Social Security system, it is still used for certain determinations within the Railroad Retirement program, the Pension Benefit Guaranty Corporation, the eligibility calculation for Social Security’s special minimum benefit, and finally, for determining the amount of earnings deemed as “substantial” for purposes of the Windfall Elimination Provision.
To calculate the Old-Law Contribution And Benefit Base, use the following formula:
(AWI from two years ago / 1992 AWI) x $45,000 (1994 old-law base)
The Old-Law base will only change in years where there is a cost of living adjustment, and this amount cannot decrease. If the calculation reflects a decrease, the Old-Law base will not change from one year to the next. And as you do when looking at the maximum taxable wage base, if the amount calculated is not a multiple of $300, it is rounded to the nearest multiple of $300.
You can see the calculation details on the Social Security website.
Coverage Thresholds (for Domestic and Election Workers)
A coverage threshold is the dollar amount of earnings that triggers Social Security coverage. Earnings under the coverage threshold are not taxable under Social Security and those earnings do not count toward future benefits.
For the vast majority of workers, there is no coverage threshold. Every dollar of earnings is taxable and counts toward a future benefit.
However, Federal law requires specific coverage thresholds for self-employed workers, farm workers, domestic employees, and election workers. The coverage thresholds for domestic employees and election workers change with changes in the national average wage index. The other listed occupation groups are fixed.
There are two separate formulas that the Social Security Administration uses here:
The formula for domestic employees is as follows:
(AWI from two years ago / 1993 AWI) x $1,000 (1995 threshold)
The formula for election workers is as follows:
(AWI from two years ago / 1997 AWI) x $1,000 (1995 threshold)
Both of these threshold calculations are rounded down to the nearest multiple of $100.
You can see the calculation examples for both domestic and election workers on the Social Security website.
Substantial Gainful Activity (SGA) for Disabled Individuals
To be eligible for disability benefits, a person must be unable to engage in substantial gainful activity (SGA).
A person who is earning more than a certain monthly amount (net of impairment-related work expenses) is ordinarily considered to be engaging in SGA. The amount of monthly earnings considered as SGA depends on the nature of a person’s disability.
The Social Security Act specifies a higher SGA amount for statutorily blind individuals. Federal regulations specify a lower SGA amount for non-blind individuals. Both SGA amounts generally change with changes in the national average wage index.
Since there are separate levels of SGA for blind and non-blind individuals, there are also two formulas here.
SGA for the Blind (does not apply to SSI):
(AWI from two years ago / 1992 AWI) x $930 (1994 monthly SGA amount)
SGA for Non-Blind (applies to SSI)
(AWI from two years ago / 1998 AWI) x $700 (2000 monthly SGA amount)
This benefit amount will only change in years where there is a cost of living adjustment, and as with many of the other benefit calculations described here, the amount cannot decrease. If the calculation reflects a decrease, SGA will not change from one year to the next.
Finally, if the amount calculated is not a multiple of $10, it is rounded to the nearest multiple of $10. You can see the calculation details for both blind and non-blind individuals on the Social Security website.
Your Next Steps
There’s no question that the Average Wage Index is the most important and impactful component in calculating new benefits and managing ongoing benefits. It’s not critical that you completely understand every piece of this puzzle to make Social Security work for you — but having a broad knowledge will help you interpret what you see on the SSA website and in communications you may receive from them.
If you still have questions, you should join my FREE Facebook members group. It’s very active and has some really smart people who love to answer any questions you may have about Social Security. From time to time I’ll even drop in to add my thoughts, too.
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