No. 1827March 2, 2005

This paper, in its entirety, can be found at: www.heritage.org/research/socialsecurity/bg1827.cfm

Produced by the Thomas A. Roe Institute for Economic Policy Studies

Published by The Heritage Foundation214 Massachusetts Avenue, NEWashington, DC 20002–4999(202) 546-4400 • heritage.org

How Today’s Social Security WorksDAVID C. JOHN

What Is Social Security?Social Security is probably the most popular

federal program, yet most people know almostnothing about it. In practice, Social Security’s com-plex benefit formulas and rules make it difficult forpeople to understand how their retirement bene-fits will work.

This paper explains what Social Security is andhow it works. The first section explains whatSocial Security is and which programs are and arenot part of Social Security. This includes a discus-sion about Social Security’s retirement, survivors,and disability programs. It also explains why Sup-plemental Security Income is not part of SocialSecurity, even though it is administered by theSocial Security Administration.

How Social Security Is FinancedThe second section explains the payroll taxes

that mainly finance Social Security and how theyare paid. It explores the level of payroll taxes usedto finance the system, how those taxes are col-lected, and what programs they fund. One factthat is often overlooked is that a worker’s paychecknormally shows only half of the Social Securitypayroll taxes that are paid on his or her behalf.

The Trust FundsThe third section explains what Social Security’s

trust funds are and are not. It examines how muchgoes into the trust funds, the sources of this

money, and how the money is spent. It also dis-cusses the annual trustees report.

As this section explains, there is no pool ofactual assets that is being reserved to pay the bene-fits of future retirees. The Social Security trustfund contains nothing more than IOUs in the formof special-issue U.S. Treasury bonds, which thefederal government can repay only though highertaxes, massive borrowing, or massive cuts in otherfederal programs. While many workers thoughtthat the system’s annual surpluses were being usedto build a reserve for future retirees, the federalgovernment has been spending this money to fundother government programs and to reduce thegovernment debt.

How Benefits Are CalculatedThe fourth and longest section discusses how

Social Security benefits are calculated and who iseligible to receive them. Social Security benefitsare determined by a complex formula that is basedon past earnings. How those past earnings areindexed so that money earned long ago has thesame purchasing power as salaries earned more

Nothing written here is to be construed as necessarily reflecting the views of The Heritage Foundation or as an attempt to aid or

hinder the passage of any bill before Congress.

No. 1827 March 2, 2005

recently is key to understanding efforts to fix thesystem. This section explains indexing and howdifferent methods could result in differentresults.

In addition, this section explains such complextopics as the Government Pension Offset, whichaffects workers who have worked in governmentjobs that are not part of Social Security; the Wind-fall Elimination Provision, which affects everyworker who has worked both in a job that is cov-ered by Social Security and in one that is not; andthe question of “notch babies.”

A companion paper will discuss the fiscal prob-lems facing the current system and why changesare necessary. All of the information contained in

this paper comes from Social Security Administra-tion sources.

ConclusionSocial Security is a remarkably complex pro-

gram, and few people actually understand how itoperates. However, if the current program’simpending financial problems are to be avoided, itbecomes increasingly important for informed citi-zens to measure different reform options againstthe existing program’s actual operating structureand practices.

—David C. John is Research Fellow in Social Secu-rity and Financial Institutions in the Thomas A. RoeInstitute for Economic Policy Studies at The HeritageFoundation.

No. 1827March 2, 2005

• Social Security is perhaps the most populargovernment program, but few peopleunderstand how it operates.

• A worker’s paycheck normally shows onlyhalf of the Social Security payroll taxes thatare paid on his or her behalf.

• Benefit formulas for Social Security areextremely complex, and terms used by theprogram often have a meaning that is dif-ferent from the meaning that the sameterms would have in other contexts.

• The Social Security trust fund contains noth-ing more than IOUs in the form of special-issue U.S. Treasury bonds, not real assets.The trust funds are essentially an account-ing mechanism that measures how muchthe government owes itself.

This paper, in its entirety, can be found at: www.heritage.org/research/socialsecurity/bg1827.cfm

Produced by the Thomas A. Roe Institute for Economic Policy Studies

Published by The Heritage Foundation214 Massachusetts Avenue, NEWashington, DC 20002–4999(202) 546-4400 • heritage.org

Talking Points

How Today’s Social Security WorksDAVID C. JOHN

Social Security is probably the most popular fed-eral program, yet most people know almost nothingabout it. In practice, Social Security’s complex bene-fit formulas and rules make it difficult for people tounderstand how their retirement benefits will work.

This paper explains what Social Security is andhow it works. The first section explains what SocialSecurity is and which programs are and are not partof Social Security. The second section explains thepayroll taxes that mainly finance Social Security andhow they are paid. The third section explains whatSocial Security’s trust funds are and are not. Thefourth and longest section discusses how SocialSecurity benefits are calculated and who is eligible toreceive them. A companion paper will discuss thefiscal problems facing the current system and whychanges are necessary. All of the information con-tained in this paper comes from Social SecurityAdministration (SSA) sources.

What Is Social Security?Social Security is the most popular government

program and touches the life of every worker inAmerica, but most people know little or nothingabout how it operates. The following discussionexplains what Social Security is and how it operates.

Social Security’s Major Programs. While mostdiscussions focus only on Social Security’s retirementprogram, Social Security actually consists of threemajor programs, all of which are administered by theSocial Security Administration. Specifically:

Nothing written here is to be construed as necessarily reflect-ing the views of The Heritage Foundation or as an attempt to

aid or hinder the passage of any bill before Congress.

March 2, 2005No. 1827

• Retirement. Social Security’s retirement programprovides a lifetime monthly income for qualifiedworkers once they reach their full retirementage. Depending on when they were born, thatage ranges from 65 to 67. The amount of retire-ment benefits that a worker receives depends onhis or her income while working. Workers alsohave the option of receiving a lower monthlyincome starting at age 62.

• Survivors. Social Security’s survivors programprovides a monthly lifetime income to the sur-viving spouse of a deceased worker once he orshe reaches retirement age. The amount of themonthly benefit depends on both spouses’income while they were working. The survi-vors program also pays benefits to childrenunder the age of 18 and the surviving spousecaring for them. Unless they are disabled, chil-dren’s benefits end when the last child eitherreaches age 18 or graduates from high school,whichever is later.

• Disability. Social Security also pays lifetimemonthly income to workers who are disabledand, in some cases, to their spouses and chil-dren under the age of 18. These benefitsdepend on the worker’s earning history.

Qualifying for Social Security. Workers do notautomatically qualify for Social Security retire-ment benefits. Instead, they must work and pay aminimum level of Social Security taxes for at least40 quarters during their working lives. These 40quarters do not have to be consecutive. Cur-rently, workers earn a credit for each three-monthperiod in which they earn at least $900. Oncethey have worked and paid Social Security taxesfor the required 40 quarters, they are fully quali-fied to receive Social Security retirement benefits.If workers have paid Social Security taxes for acertain number of quarters in the recent past,1

they are also qualified to receive disability bene-fits and to have survivors benefits paid to theirspouses and to their children who are under theage of 18.

Disability benefits are paid to workers who havebeen disabled for at least one year. In order toqualify, a worker must have paid Social Securitytaxes within the recent past. “Disabled” in this casemeans unable to perform any substantial gainfulwork due to severe physical or mental impair-ment. Determination of eligibility is based onmedical evidence and made by a governmentagency in the state in which the worker lives.

There is no requirement that an individual mustbe an American citizen to qualify for Social Security.While employers are required by other laws toensure that anyone they hire is either a citizen or alegal immigrant, foreign nationals can earn SocialSecurity credits with a valid Social Security number.

Supplemental Security Income. The Supple-mental Security Income (SSI) program is not partof Social Security. Even though the Social SecurityAdministration administers SSI, the program ispaid for with general tax revenues. No Social Secu-rity payroll taxes are used to pay for SSI. SSI helpsaged, blind, and disabled people who have little orno income. It provides cash to meet basic needsfor food, clothing, and shelter. To get SSI, a workermust be blind, disabled, or at least 65 years of age.

Medicare. Medicare is a federal program thathelps to pay for older Americans’ health costs.Some people incorrectly consider Medicare to bepart of the Social Security system because taxesthat finance part of Medicare are lumped in withthose that pay for Social Security. However, Medi-care is also financed by premiums and general rev-enue, and it is not administered by the SocialSecurity Administration. For these reasons, Medi-care is not considered part of Social Security.

FICA. The taxes that pay for Social Security’sprograms are confusing to most people. On mostworkers’ paychecks, the taxes that pay for bothSocial Security and Medicare are lumped togetherunder the term “FICA” (Federal Insurance Contri-butions Act). Even the amount under FICA is mis-leading because it shows only half of the taxes paidon the worker’s behalf.

1. The number of quarters required to qualify for disability benefits depends on the age at which the worker became dis-abled.

page 2

No. 1827 March 2, 2005

Payroll Taxes and AmountsUnlike most other government programs, Social

Security (like Medicare) is funded through explicittaxes that are not supposed to be used for anyother purpose. These taxes are based on a worker’searned income and deducted from his or her pay-checks. For that reason, Social Security taxes areoften referred to as “payroll taxes.” These payrolltaxes are in addition to any income taxes that theworker must pay.

Separate payroll taxes finance Social Security’sretirement and survivors benefit program, SocialSecurity’s disability benefit program, and Medi-care; yet the three are often lumped together asone line item on a worker’s pay stub. The twoSocial Security taxes are paid only on income up toa certain annual amount. Medicare taxes are col-lected on all earned income.

In 2005, workers and employers will pay pay-roll taxes totaling 15.3 percent of the first $90,000of income and 2.9 percent of income above thatamount. The $90,000 dividing line is called the“earnings limit”—sometimes referred to as the“wage cap.” Of that 15.3 percent total, 10.6 per-cent of income pays for Social Security’s retirementand survivors program, and 1.8 percent pays forSocial Security’s disability program. The remaining2.9 percent is used to pay for Medicare programs,but the Medicare taxes are not subject to the earn-ings limit. In other words, Medicare taxes are col-lected on all of a worker’s earned income, not justthe first $90,000.

The worker and the employer each pay half of thepayroll taxes. The self-employed pay both portions.

FICA Defined. The paycheck stubs from mostemployers do not show the individual amountsthat the worker pays for Social Security and Medi-care. Instead, these taxes are lumped together andshown as a deduction for “FICA.”

The Federal Insurance Contributions Act is thepart of the Internal Revenue Code that gives thefederal government the authority to collect thepayroll taxes that pay for the Social Security pro-grams and part of Medicare. The name implies thatthe taxes for these programs are actually contribu-tions to a social insurance system. In reality, how-

ever, they are nothing more than taxes, and itwould be more honest to refer to them as such.

Matching Deductions by the Employer. Inmost cases, only half of the Social Security taxesthat a worker pays are shown on the paycheckstub. Employers also pay an equal amount of pay-roll taxes on the worker’s behalf. As far as theemployer is concerned, these additional taxes arepart of the worker’s pay. Even though the workernever sees this income, the employer actually pays$10,765 for each $10,000 the worker earns($10,000 in wages and $765 in payroll taxes). Ifthat worker were not employed, the employerwould not be required to pay the $765 in taxes.

If this money was not paid to the government aspayroll taxes, it could go to the worker as wages.For this reason, both halves of the FICA tax shouldbe counted as being paid by the worker. Thus,instead of paying taxes equal to 5.3 percent ofincome for retirement and survivors benefits, theworker is actually paying 10.6 percent of income.The combined total is the true cost to each worker.

Self-Employed Workers. This reality is clearlyillustrated by self-employed workers, who mustpay both the employer and the employee halves ofthe payroll taxes. Combining the payroll taxes forSocial Security’s retirement and survivors program,Social Security’s disability program, and Medicare,the self-employed pay a total of 15.3 percent ofincome below $90,000 in 2005 and 2.9 percent ofincome above that amount. These payroll taxes arein addition to any income taxes.

Retirement and Survivors Tax. The largestportion of FICA payroll taxes is used to pay for aworker’s retirement and survivors benefits. Thetaxes pay for both the monthly benefits to workerswho have retired and the monthly benefits (afterthe worker’s death) to their surviving spouses andchildren (under the age of 18). The worker andemployer each pay 5.3 percent for a total of 10.6percent of income up to the earnings limit forthese programs. These taxes go into the Old-Ageand Survivors Insurance (OASI) trust fund.

Disability Tax. Taxes equal to 1.8 percent ofincome (up to the earnings limit) go into the Dis-ability Insurance (DI) trust fund and pay monthly

page 3

March 2, 2005No. 1827

benefits to workers who are unable to work dueto a long-term physical or mental disability. Aswith all payroll taxes, half of the amount (0.9percent of income) is deducted from the worker’spay, and the employer pays the other half on theworker’s behalf.

The Earnings Limit. In 2005, Social Securitytaxes will be collected on only the first $90,000that a worker earns. This figure is known as the“earnings limit” and is adjusted each year. SocialSecurity benefits are paid only on the amount ofincome that is subject to the Social Security payrolltax. Thus, in Social Security’s eyes, both MichaelJordan and Bill Gates earn $90,000 per yearregardless of their actual incomes, and their SocialSecurity retirement benefits will reflect this.

The earnings limit protects Social Securityfrom having to pay benefits on Bill Gates’s entireincome. It allows the program to say that it cov-ers all Americans without paying the very richbenefits that are much higher than those that goto average-income workers. Every October,Social Security calculates and announces theearnings limit for the following calendar year,based on the growth of wages in the economy.Wage growth is slightly higher than the rate ofinflation (growth of prices).

Developed as part of the 1983 Social Securityreforms, this formula for increasing the amount ofwages that are taxed for Social Security was sup-posed to cover 90 percent of the nation’s totalwages. However, this proportion has graduallydeclined and is now closer to 85 percent.

Income Taxes on Some Social Security Bene-fits. Since 1983, retirees with annual incomeabove a certain amount have been required to payincome taxes on a portion of their Social Securitybenefits. The money raised through this tax isreturned to either Social Security or Medicare.

Retirees who earn between $25,000 and$34,000 and file as individuals may have to payincome taxes on up to 50 percent of their benefits.If they earn more than $34,000, they may have topay income taxes on up to 85 percent of their ben-efits. Married retirees who earn between $32,000and $44,000 may have to pay income taxes on up

to 50 percent of their benefits, and if they earnover $44,000, up to 85 percent of their benefitsmay be taxable. These income thresholds are notindexed for inflation. Income taxes on Social Secu-rity benefits are paid at the same rates as on othertypes of earned income.

Until 1983, all Social Security benefits wereincome tax free. In that year, Congress decided totax 50 percent of the Social Security benefits ofworkers with total retirement incomes over$25,000 (for single retirees) because Social Secu-rity needed additional revenue. Congress justifiedthe move by pointing out that the half of payrolltaxes paid by employers can also be deducted fromthe employer’s corporate income taxes, whileworkers must pay income taxes on the amount oftheir check that is deducted as payroll taxes. Con-gress decided that since companies received a taxdeduction on the amount of payroll taxes paid onbehalf of their workers, Congress could recapturethat tax benefit by assessing income taxes on halfof some retirees’ benefits.

In 1993, problems with financing Medicare ledCongress to raise the proportion of Social Securitybenefits that is subject to income taxes to 85 per-cent for workers with incomes over $34,000 (forsingle retirees). The money raised from this taxgoes to the Health Insurance trust fund.

The Social Security Trust FundsMany people tend to think of their Social Secu-

rity benefits as coming from an actual account, intheir name, which contains cash or investments.People who believe this often point to the exist-ence of the Social Security trust funds to justifytheir belief. However, this belief is fallacious fortwo reasons. First, Social Security has no individ-ual accounts at all, other than a bookkeepingrecord of an individual’s yearly earnings and pay-roll taxes. Second, the program’s trust funds donot contain cash or saleable assets. They onlyrepresent the amount of Social Security taxes col-lected beyond what the program needs to paycurrent benefits.

In reality, the Social Security trust funds containnothing more than IOUs that have no valuebeyond a promise to impose higher taxes on future

page 4

No. 1827 March 2, 2005

workers. The annual surpluses that many thoughtwere being used to build up a reserve for babyboomers have been spent to fund other govern-ment programs or to reduce the government debt.

The OASI and DI Trust Funds. Social Securityhas two trust funds: the Old-Age and SurvivorsInsurance trust fund and the Disability Insurancetrust fund. These two trust funds are linked andare often referred to as a single trust fund, the Old-Age, Survivors, and Disability Insurance trustfund, or OASDI.

Despite the fact that there are two trust funds,most of the estimates of Social Security’s financesuse the combined OASDI trust fund, which is animportant distinction. For instance, according tothe 2004 trustees report, OASDI will begin tospend more than it takes in by 2018. Consideredseparately, the OASI trust fund is also predicted tobegin to spend more than it takes in each yearstarting in 2018, but the DI trust fund will beginto spend more than it takes in starting in 2009.

In addition to the two Social Security trustfunds, there is a Health Insurance (HI) trust fundthat partially funds Medicare. The HI trust fund ismanaged and invested in the same way as theOASI and DI trust funds but is outside the scopeof this paper.

The Trustees and Their Annual Report. Thesame trustees manage the OASI, DI, and HI trustfunds. Three of the six trustees are Cabinet officials:the Secretary of the Treasury, Secretary of Labor, andSecretary of Health and Human Services. The Secre-tary of the Treasury serves as the managing trustee.In addition, the Commissioner of Social Security isa trustee, and two public trustees are appointed bythe President and confirmed by the Senate for four-year terms. The terms of public trustees John L.Palmer and Thomas R. Saving expired in October2004, but they can continue in their roles until the2005 trustees report is released.

Every year, the trustees are required to issue areport that details both the financial activities inthe trust funds and the long-term and short-termoutlooks for Social Security’s programs. Availablefrom SSA both on-line and in published copies,these annual reports contain a wealth of numbers,

statistics, and predictions. In addition to the num-bers from the most recent year, the reports predictSocial Security’s financial status for both the next10 years and the next 75 years.

Recently, the trustees have also developed aperpetual measure that extends well beyond the75-year measure. This is intended to respond tocritics who fail to understand that any reformthat is based on the 75-year measure alone couldleave the system on a path that would result inhuge new deficits just one year beyond that 75-year horizon.

The report includes predictions based on themost likely economic scenario as well as bothmore optimistic and more pessimistic outcomes.Some analysts make the mistake of assuming thatthe three outcomes are equally likely to happen.However, a deeper analysis shows that there isonly an extremely small chance that either theoptimistic or the pessimistic outcome will happen,while there is a very high chance that the mostlikely outcome will occur. For that reason, themost recent trustees reports include a stochasticanalysis that shows the probabilities of each out-come’s actually happening.

Often, press reports focus on the simplest statis-tics, such as the year in which the trust funds arepredicted to run out of assets. However, a morecareful examination reveals other important infor-mation, such as the amount that Social Securityowes in promised benefits beyond what it can paywith payroll taxes. The report also indicates theyear in which the programs must begin to spendmore than they receive in payroll taxes. These areactually more important to determining the pro-grams’ ability to meet the needs of those whodepend on them.

The OASI Trust Fund. The Old-Age and Survi-vors Insurance trust fund—by far the larger of thetwo Social Security trust funds—pays retirementand survivors benefits. In 2003, the OASI trustfund had a total income of $543.8 billion. Of thattotal, $456.1 billion (83.9 percent) came frompayroll taxes; $12.5 billion (2.3 percent) camefrom income taxes paid on higher-income retirees’Social Security benefits; and $75.2 billion (13.8

page 5

March 2, 2005No. 1827

percent) came from interest paid on special-issueTreasury bonds in the trust fund.

During 2003, the trust fund paid out $399.8billion in benefits (73.5 percent of tax receipts)and $2.6 billion (0.5 percent) for administrativeexpenses. The remaining $137.8 billion (25.3 per-cent) was retained in the trust fund. As a result,the trust fund’s assets grew from $1.217 trillion atthe beginning of the year to $1.355 trillion at theend of 2003.2

The Disability Insurance Trust Fund. TheDisability Insurance trust fund—the smaller of thetwo Social Security trust funds—pays disabilitybenefits. In 2003, the DI trust fund had a totalincome of $88.1 billion. Of that total, $77.4 bil-lion (87.9 percent) came from payroll taxes; $0.9billion (1.0 percent) came from income taxes paidon higher-income workers’ disability benefits; and$9.7 billion (11.0 percent) came from interest paidon special-issue Treasury bonds in the trust fund.

During 2003, the trust fund paid out $70.9 billion(80.5 percent of tax receipts) in benefits and $2.0 bil-lion (2.3 percent) for administrative expenses. Theremaining $15.0 billion (17.0 percent) was retainedin the trust fund. As a result, the trust fund’s assetsgrew from $160.4 billion at the beginning of the yearto $175.4 billion at the end of 2003.3

The disability program’s separate trust fund andtax structure, combined with the completely dif-ferent eligibility criteria for receiving disabilitybenefits, distinguish it from the retirement andsurvivors program. The disability program is a trueinsurance program, while the retirement and sur-vivors program is much closer to a retirementinvestment program.

How the Social Security Trust Funds Differfrom Real Trust Funds. Private-sector trust funds

invest in real assets, ranging from stocks and bondsto mortgages and other financial instruments.Assets are held only for a specific purpose, and thefund managers are liable if the money is misman-aged. Funds are managed in order to maximizeearning within a pre-agreed risk level. Investmentsare chosen to provide cash at set intervals so thatthe trust fund can pay its obligations.

The Social Security trust funds are very differ-ent. As explained by the Office of Managementand Budget (OMB):

The Federal budget meaning of the term“trust” differs significantly from the privatesector usage…. [T]he Federal Governmentowns the assets and earnings of mostFederal trust funds, and it can unilaterallyraise or lower future trust fund collectionsand payments, or change the purpose forwhich the collections are used.4

Even more important, the Social Security trustfunds are “invested” only in a special type of Trea-sury bond that can only be issued to andredeemed by the Social Security Administration.These bonds cannot be sold to the public to raisemoney. They are only a measure of what the gov-ernment owes itself. As the CongressionalResearch Service noted:

When the government issues a bond to oneof its own accounts, it hasn’t purchasedanything or established a claim againstanother entity or person. It is simplycreating a form of IOU from one of itsaccounts to another.5

As a result:

These [Trust Fund] balances are available tofinance future benefit payments and other

2. Social Security Administration, 2004 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Disability Insurance Trust Funds (Washington, D.C.: U.S. Government Printing Office, 2004), p. 19, at www.ssa.gov/OACT/TR/TR04 (February 18, 2005).

3. Ibid., p. 23.

4. Office of Management and Budget, Budget of the United States Government, Fiscal Year 2000: Analytical Perspectives (Wash-ington, D.C.: U.S. Government Printing Office, 1999), p. 335.

5. David Koitz, “Social Security and the Federal Budget: What Does Social Security’s Being Off-Budget Mean?” Congressional Research Service, May 5, 1998.

page 6

No. 1827 March 2, 2005

trust fund expenditures—but only in abookkeeping sense. These funds are not setup to be pension funds, like the funds ofprivate pension plans. They do not consistof real economic assets that can be drawndown in the future to fund benefits. Instead,they are claims on the Treasury, that, whenredeemed, will have to be financed byraising taxes, borrowing from the public, orreducing benefits or other expenditures.The existence of large trust fund balances,therefore, does not, by itself, make it easierfor the government to pay benefits.6

In short, the Social Security trust funds arereally only an accounting mechanism. They showhow much the government has borrowed fromSocial Security but do not provide any way tofinance future benefits.

How Money Goes to and from the TrustFund. An employer pays taxes to the Treasury byperiodically sending a check (or electronic transfer)that includes both income taxes and payroll taxes.The check is sent without distinguishing betweenpayroll and income taxes. There is also no indica-tion of which individual employees’ taxes are beingpaid or how much those employees earned.

On a regular basis, the Treasury estimates howmuch of its aggregate tax collections are due toSocial Security taxes and credits the trust fundswith that amount. No money actually changeshands: This is strictly an accounting transaction.These estimates are corrected after income taxreturns show how much in payroll taxes was actu-ally paid in a specific year. In addition, the Trea-sury credits the trust funds with interest paid onits balances and with the amount of income taxesthat higher-income workers pay on their SocialSecurity benefits.

To pay benefits, the Social Security Administra-tion directs the Treasury to pay monthly benefits,and that amount is subtracted from the total in thetrust funds. Any remainder is converted into spe-cial-issue Treasury bonds, which are really nothingmore than IOUs.

After the trust fund has been credited with theIOUs, Social Security’s extra tax revenue is thenspent by the Treasury just as any other taxes arespent. If the federal budget is running a surplus,that amount could be used to repay federal debtowned by the public. Otherwise, it is spent on anyother type of federal program, ranging from air-craft carriers to education research.

Special Securities Issued to the Trust Funds.The Social Security trust fund consists only of spe-cial-issue Treasury bonds. These bonds are specialin that they can only be issued to and redeemed bythe Social Security trust funds. They cannot besold in the open market.

The Social Security trust fund bonds pay thesame interest rate as regular Treasury bonds issuedon the same day with the same maturity date. Whenthe bonds mature, they are rolled over into newbonds that include both the original issue amountand any interest due. The new bonds also pay thesame interest rate as comparable Treasury bonds.

Because these are special-issue bonds that arepayable only to the Social Security Administration,the SSA cannot sell them to a third party to raisemoney to pay benefits. This reinforces the fact thatthese bonds are really nothing more than IOUsfrom one branch of government to another. Theyare not a real financial asset.

Until relatively recently, these bonds existedonly as entries in a record book. Now, however,when a new bond is issued, it is printed on a laserprinter located at the Bureau of the Public Debtoffice in Parkersburg, West Virginia. The bond isthen carried across the room and put in a fireprooffiling cabinet. That filing cabinet is the SocialSecurity trust funds.

How Trust Fund IOUs Would Be Repaid. Atsome point in the future, probably starting about2018, Social Security will start to pay more inbenefits than it receives from payroll taxes. Atthat point, it will begin to cash in the bonds inthe trust fund. According to the most recenttrustees report, Social Security will cash about$5.7 trillion (in 2004 dollars) in special-issue

6. Office of Management and Budget, Analytical Perspectives, p. 337; emphasis added.

page 7

March 2, 2005No. 1827

bonds, cashing the first special-issue bond in2018 and the last bond in 2042.

According to the OMB, there are only fourways that Congress can repay these bonds: raiseother taxes, authorize the Treasury to borrow theneeded funds from the public, reduce spendingon other federal programs and use the savings toredeem Social Security’s bonds, or simply reduceSocial Security benefits. None of these options iseasy or attractive.

Determining Social Security BenefitsSocial Security benefits are based on earnings

averaged over most of a worker’s lifetime. Mostpeople know about Social Security’s retirementbenefits, but the program also pays benefits to dis-abled workers. In addition, families can receivebenefits under certain circumstances. The formulathat the agency uses to determine the benefits for aworker or the worker’s family is complex. Compli-cating matters even more are a number of specialcircumstances that can alter those benefits.

What follows is a general analysis that is suit-able for policymakers. For individual cases, itwould be wiser to seek guidance from either theSSA or other sources.

When Can a Worker Retire? There are twoanswers to this question. A worker can begin tocollect Social Security retirement benefits as earlyas age 62 but cannot begin to receive full retire-ment benefits until between ages 65 and 67. Theexact age for full benefits depends on the worker’sbirth date. Workers born before 1938 can receivefull retirement benefits starting at age 65. The fullretirement age increases by two months per yearfor workers born between 1938 and 1942 and is66 for those born between 1943 and 1954. Thefull benefits age then increases by two months peryear for those born between 1955 and 1959 and is67 for anyone born in 1960 or after.

If a worker decides to receive benefits starting atage 62, the monthly benefits will be reduced by aset percentage for each month that the workerreceives benefits before full retirement age. As thefull retirement age increases from 65 to 67, work-ers who retire early will receive an even greater

reduction in their monthly benefits. Currently, aworker who retires at 62 will receive 80 percent ofthe full retirement age amount. This will eventu-ally drop to 70 percent for those with a full retire-ment age of 67.

Even after a worker reaches full retirement age, theworker’s benefits continue to increase every monthuntil that worker applies to receive retirement bene-fits. This benefit growth continues until age 70.

Qualifying for Retirement Benefits. Not every-one is qualified to receive Social Security benefits.To qualify, a worker must earn at least 40 quarterlycredits. A worker earns one credit by earning atleast $900 in a three-month period and payingSocial Security taxes on that amount. Workers whoearn $3,600 during a year earn four credits.

The amount of income required to earn a creditis adjusted annually, but this does not affect creditsthat have already been earned. Once a worker hasearned the required 40 credits, he or she is perma-nently qualified. However, the level of benefitsdepends on worker’s income history.

The Disability Insurance program has similarrequirements, but the number of credits necessaryto qualify varies depending on the age at which theworker becomes disabled. In general, the youngerthe person who is disabled, the lower the numberof credits required to qualify for benefits.

The General Formula for Retirement Bene-fits. Retirement benefits are based on a worker’shighest 35 years of earnings. Those wages areindexed so that all 35 have the purchasing powerof the year when the person retires. The worker’sAverage Indexed Monthly Earnings (AIME), oraverage monthly salary, is calculated using the 35years of indexed earnings. The AIME is then runthrough a formula that calculates benefits equal to90 percent of AIME up to a certain level ofmonthly income, 32 percent of AIME from thatlevel to a higher point, and 15 percent of theremaining AIME.

The dividing points between the three paymentlevels are known as “bend points.” The three pay-ment levels are added up to find the worker’smonthly Social Security retirement benefit. Bothsteps are detailed below.

page 8

No. 1827 March 2, 2005

Determining Average Indexed Monthly Earn-ings (AIME). Retirement benefits are calculatedusing a worker’s highest 35 years earnings. Theydo not have to be consecutive years. If the workerhas an earnings record for more than 35 years,only the 35 years of highest earnings are includedin the calculation; years with lower earnings aredropped. Only those earnings on which theworker paid Social Security taxes are counted.Thus, if the worker earned $100,000 in 2004, thatyear’s income would be counted as $87,900 fordetermining benefits, since the worker only paidSocial Security taxes on the lower amount.

Except for the two years immediately prior toretirement, earnings for previous years are indexedso that all years are measured by the same abilityto purchase goods and services; the two yearsimmediately before retirement are not indexed.This indexing increases past earnings to accountfor both inflation and increases in average wagegrowth. For instance, it would take $12.05 in2004 dollars to equal $1.00 earned in 1951, and$1.61 to equal $1.00 earned in 1990.

Once the 35 years of highest earnings are deter-mined, they are totaled and divided by 420 (thenumber of months in 35 years). The result is theAverage Indexed Monthly Earnings, which is usedto calculate Social Security benefits.

Some jobs—usually for state or local govern-ments—are not covered by Social Security, andearnings for those jobs are not included in calcu-lated AIME. For the purposes of determiningSocial Security benefits, those years count thesame as if the worker was not employed.

If a worker did not work for a full 35 years—perhaps due to raising a family or because of ill-ness—the missing years are counted as zeros. Forexample, if a worker is either employed for only25 years or worked in a job covered by SocialSecurity for only 25 years, the indexed earningsfrom those 25 years are added together anddivided by 420. This lowers that worker’s AIME toaccount for the missing years. Social Security ben-

efits earned by state and local government workersare adjusted in other ways, as explained in the sec-tions on the Government Pension Offset and theWindfall Elimination Provision.

Wage Indexing vs. Price Indexing. In creatingAIME, a worker’s past wages are indexed to bringthem to the same level as today’s earnings. Thereare two general ways to index past earnings andpotentially dozens of variations on these two thatwould create results that lie in between the twogeneral methods. This calculation is done onlyonce in a worker’s life—when he or she firstapplies for Social Security benefits. Once theworker’s initial monthly benefit has been deter-mined, it is price indexed in each successive yearto protect the retiree from inflation.

Price indexing is based upon the ConsumerPrice Index (CPI) and compensates for inflation.Price indexing benefits ensures that they maintaintheir constant purchasing power. In this case, ifinflation had increased by 5 percent since last year,simply multiplying the previous year’s benefit by1.05 would preserve the retiree’s ability to buy thesame amount of goods as last year.

By contrast, wage indexing is based on thegrowth in average wages in the economy over aset period of time and is supposed to allow work-ers to retire with the same standard of living. Thegrowth in average wages includes both inflationand growth in the overall economy. As a result,wage indexing almost always results in a higherAIME than price indexing. Social Security useswage indexing only when calculating AIME,determining the annual level of bend points inthe benefit level, and determining the annuallevel of the payroll tax earnings cap.

The difference between the two forms of index-ing can be important. If a worker had been a brick-layer throughout his or her career and earned $4.00per hour in 1980, indexing that amount for infla-tion (an increase of 129.3 percent) would result inan indexed wage of $9.17 per hour.7 On the otherhand, indexing for average growth in wages (an

7. Social Security Administration, “CPI for Urban Wage Earners and Clerical Workers,” updated January 19, 2005, at www.socialsecurity.gov/OACT/STATS/cpiw.html (February 18, 2005).

page 9

March 2, 2005No. 1827

increase of 172 percent) would result in $10.88 perhour.8 While it is true that $9.17 in 2004 wouldbuy the same amount as $4.00 in 1980, the averagewage for a bricklayer could have increased to some-thing closer to $10.88 per hour in 2002.

Wage indexing allows retirees to take advantageof the increase in the standard of living over theirworking careers. However, it is often criticized asgiving workers a retroactive credit for improve-ments in the economy. In other words, theworker’s 1980 wages are being measured accord-ing to the economy of 2004 rather than accordingto the 1980 economy in which they were earned.

The key difference is in replacement rates. Thereplacement rate is the proportion of a worker’saverage monthly earnings that is paid by thatworker’s Social Security retirement benefit. Cur-rently, Social Security pays average-income work-ers a retirement benefit that is equal to between40 percent and 45 percent of their averagemonthly earnings. Lower-income workers gener-ally receive a higher proportion of their averagemonthly earnings, while higher-income workersreceive a lower proportion.

With wage indexing, these replacement rateswill remain roughly stable. On the other hand,changing to price indexing will gradually reducethe replacement rates. While this would bringpromised Social Security benefits closer to whatthe program can afford to pay, it would alsorequire workers to make up the difference fromeither savings or some other form of retirementplan. Most experts believe that a retiree needs anincome equal to roughly 70 percent of pre-retire-ment income for a comfortable retirement.

Annual COLA Increases. Once a worker’smonthly benefits have been determined, they areincreased every year by the rate of inflation. ThisCost of Living Adjustment (COLA), is intended topreserve the purchasing power of a recipient’s ben-efits. The amount of the annual increase isannounced each October and takes effect the fol-lowing January.

The COLA is based on the inflation rate for thepreceding 12 months from October 1 to Septem-ber 30. For example, in October 2004, the SSAannounced a COLA increase of 2.7 percent for allchecks issued after January 1, 2005. This increasewas based on the change in CPI-W from October1, 2003, through September 30, 2004.

The SSA currently uses the Department of Labor’sConsumer Price Index for Urban Wage Earners andClerical Workers (CPI-W) to measure inflation, butthe law allows it to substitute other inflation indexesor the annual increase in average wages under somecircumstances.

Using Bend Points to Calculate the MonthlyBenefit. Once an AIME has been determined, theSSA calculates a worker’s monthly retirement ben-efit using a formula that pays a higher benefit rela-tive to income to lower-income workers than tohigher-income workers. In 2004, Social Securitypaid 90 percent of the first $612 of a worker’sAIME, 32 percent of the AIME amount between$612 and $3,689, and 15 percent of any AIMEamount over $3,689. The dividing points in thisformula are called “bend points.” The SSA adjuststhe bend points each year.

The bend points ensure that a lower-incomeworker receives Social Security retirement benefitsthat are comparatively higher relative to pre-retire-ment income than upper-income workers receive.For example, a worker with an AIME of $4,000 (oran average annual income of $48,000) would receive90 percent of the first $612 ($550.80); 32 percent ofthe amount between $612 and $3,689 ($984.64);and 15 percent of the amount between $3,689 and$4,000 ($46.65). Thus, the worker’s monthly benefitwould be $1582.09, or about 40 percent of AIME.

On the other hand, a worker with an AIME ofonly $1,200 (or an average annual income of$14,400) would receive 90 percent of the first $612($550.80) and 32 percent of the amount between$612 and $1,200 ($188.16), for a total monthlybenefit of $738.96. This lower monthly benefitamount would equal 61 percent of his or her AIME.

8. Social Security Administration, “National Average Wage Index,” updated October 19, 2004, at www.socialsecurity.gov/OACT/COLA/AWI.html (February 18, 2005).

page 10

No. 1827 March 2, 2005

The Spousal Benefit. In addition to the retire-ment benefits that a worker can receive, theworker’s spouse can also receive a benefit in somecircumstances. Almost all spouses who qualify forthe full benefit come from single-earner families inwhich one spouse was employed and the otherstayed at home to care for the family. The spousalbenefit is equal to 50 percent of the employedspouse’s benefit, which means that such familiescould receive a total Social Security income of 150percent of the working spouse’s benefit while bothare still alive.

The “dual entitlement rule” prevents spouseswho qualify for their own Social Security retire-ment benefits from receiving both their own bene-fits and a spousal benefit. An exception is made ifthe lower-earning spouse’s benefits are less than 50percent of the higher-earning spouse’s benefits. Inthat case, the lower-earning spouse would alsoqualify for a spousal benefit equal to the differencebetween his or her retirement benefits and 50 per-cent of the higher-earning spouse’s benefits.

Some special circumstances—for example, ifone spouse was employed by a state or local gov-ernment that is not part of Social Security—canmake it appear that someone qualifies for spousalbenefits even though they may have substantialincome or retirement benefits from the non–SocialSecurity job. The Government Pension Offsetaddresses this circumstance and limits spousalbenefits to families that truly qualify for it.

Survivors Benefits. The amount of the survi-vors benefits paid to spouses and children underthe age of 18 depends on the earnings history ofthe deceased worker. The same formula that calcu-lates retirement benefits is also used for survivorsbenefits. They are usually calculated as a percent-age of the benefit for which a worker would havebeen eligible at the time of death.

Surviving spouses near retirement age receive abenefit that is based on the worker’s retirementbenefit. If the worker began to receive benefits at afull retirement benefits age, the surviving spousewill receive an amount equal to 100 percent of theworker’s benefits. This is also true if the workerdied before begining to receive Social Security.

However, if the surviving spouse is also entitled toreceive benefits, he or she will receive only thelarger of the two amounts. The survivor will notreceive both the worker’s benefit and his or herown benefit.

If the deceased worker began to receive a reducedamount of retirement benefits before full retirementage, the surviving spouse will also receive a reducedmonthly benefit. The exact amount depends on thesurvivor’s age and the level of the worker’s benefit. Asurviving spouse can receive benefits as young asage 60, but in that case would receive only 71.5percent of the worker’s full retirement-age benefit.As the full retirement age increases, this percentagewill also change.

In addition to the monthly benefit, survivingspouses receive a one-time $255 death benefit.This benefit is payable only to spouses or childreneligible to receive benefits.

Another situation occurs if the worker dies leav-ing children under the age of 18. In that case, boththe child and the surviving spouse are eligible toreceive a benefit equal to 75 percent of the retire-ment benefit for which the worker was qualified atthe time of death. Both children and the spousecontinue to receive this benefit until the last childreaches age 18 or graduates from high school,whichever is later. Benefits are also payable up toage 19 if the child is in high school at that date orage 22 if the child is disabled. The total annualamount that the family can receive from SocialSecurity depends on a number of factors but isbetween 150 percent and 188 percent of theworker’s full retirement benefit amount. Once thelast child has reached an age at which benefits end,benefits also end for the surviving spouse until heor she qualifies for retirement benefits.

Disability Benefits. Currently, disability benefitsare calculated using the same formula as the oneused to calculate retirement benefits. However, dis-ability benefits for a worker who is disabled beforehaving worked 35 years are calculated using ashorter work history so that the worker is notpenalized for not having worked as long.

Obtaining approval for Social Security disabilitybenefits is not easy. The agency’s definition of dis-

page 11

March 2, 2005No. 1827

ability is extremely strict, and about half of work-ers who apply for benefits are turned down. Someof these applicants will be approved on appeal, butthe process can be long and complicated.

To qualify, a worker must be unable to do anykind of substantial work because of physical ormental disabilities, which are expected either tolast at least 12 months or to result in death. Merelybeing unable to do the job that he or she heldbefore the disability does not automatically qualifya worker for disability benefits. Depending on theworker’s age, experience, and education, theworker may be regarded as qualified for otherwork and thus be denied disability benefits, even ifthe work is at a lower salary. Family members mayalso be eligible to receive benefits because of aworker’s disability.

Because the disability insurance program func-tions as a true insurance program with its own tax,trust fund, and eligibility process, it is consideredto be separate from Social Security’s retirement andsurvivors program.

The Retirement Earnings Limit: WorkingDuring Retirement. Until recently, any workerunder the age of 70 who received Social Securityretirement benefits and chose to return to workwould lose a substantial portion of his or herSocial Security benefits. However, Congress elimi-nated this penalty for workers who have reachedfull retirement age. Workers between 62 and fullretirement age still risk losing much or most oftheir benefits if they choose to work after applyingfor retirement benefits.

In 2005, workers under full retirement age canearn up to $12,000 without any consequences.However, for every two dollars they earned overthat amount, their Social Security benefits werereduced by one dollar. A higher limit applies to theyear in which the worker reaches age 65.

Rather than equally reducing each monthly ben-efit, Social Security frontloads the reduction untilthe amount of the reduction is reached. Thus, ifannual benefits were to be reduced by $4,500 andthe worker’s monthly benefit was $1,000 permonth, the worker would not receive Social Secu-rity checks for the first four months, and the check

for May would be for only $500. Starting in June,the worker would again receive $1,000 per monththrough December.

The Government Pension Offset. The Gov-ernment Pension Offset affects the Social Securitybenefits for spouses of workers who held jobs thatwere not covered by Social Security. Most of theseworkers were either state or local governmentemployees or were federal employees prior to1984. Since government workers who were notcovered by Social Security do not have an earningsrecord for those jobs or any Social Security bene-fits based on that employment, they would theo-retically qualify for a full spousal benefit, eventhough the spouse would not qualify if both work-ers had been part of Social Security.

Thus, a person who joined the federal govern-ment prior to 1984 would, in theory, be able toreceive both a full Civil Service Retirement System(CSRS) pension and a Social Security spousal ben-efit. To eliminate this dual benefit, Congress cre-ated the Government Pension Offset in 1977.

Under the Government Pension Offset, two-thirds of the CSRS pension (or in other cases, thepension that comes from a state or local govern-ment that does not participate in Social Security) istreated as if it were a Social Security benefit, andthe worker’s Social Security spousal benefit isreduced dollar for dollar by this amount.

For example, if the CSRS worker’s spousereceives $1,200 per month from Social Security,the worker would technically be eligible for aSocial Security spousal benefit of $600 (one-half ofthe spouse’s basic retirement benefit). However, ifthe worker has a $1,200 per month CSRS pension,$800 of his or her pension (two-thirds) would betreated as coming from Social Security. This wouldeliminate the spousal benefit because two-thirds ofthe CSRS pension ($800) is larger than the poten-tial spousal benefit ($600).

As a result of the Government Pension Offset,the CSRS worker and the worker’s spouse aretreated the same as married workers who are bothcovered by Social Security. The Government Pen-sion Offset affects about 300,000 retirees andreduces Social Security’s aggregate benefits by

page 12

No. 1827 March 2, 2005

approximately $1 billion annually. A major pro-portion of those affected by this rule are retiredfederal workers, and most of the rest wereemployed by state and local governments that donot participate in Social Security. The vast majorityof these workers come from eight states: Alaska,California, Colorado, Louisiana, Maine, Massachu-setts, Nevada, and Ohio.

The Windfall Elimination Provision. TheWindfall Elimination Provision is similar to theGovernment Pension Offset, except that it appliesto the retirement benefits instead of spousal bene-fits. It applies only to workers who have both aSocial Security retirement benefit and a pensionfrom a job that was not part of Social Security.

Under the Windfall Elimination Provision, only40 percent (as opposed to the usual 90 percent) ofthe first $612 (the first bend point in 2004) of theAIME is counted toward the worker’s monthlyretirement benefit. This in turn lowers the affectedworker’s total monthly benefit. For example, themonthly benefit for a worker with an AIME of$1,200 would be reduced from $739 to $433, anda worker with an AIME of $4,000 would receive$1,276.09 per month instead of $1582.09.

There are exceptions to this provision that takeinto account how long the worker was employedin a job covered by Social Security. The longer aworker was employed in a job covered by SocialSecurity, the lower the benefit reduction. If theworker received “substantial” Social Security cov-ered earnings for 30 years or more, there is noreduction in benefits. In the case of a worker withthat level of earnings for 21 and 29 years, the 90percent multiplier would be reduced to between45 percent and 85 percent, depending on theexact number of years worked.

The Windfall Elimination Provision adjusts thebenefit formula to reflect retirement income fromemployment not covered by Social Security. It wascreated because the basic Social Security benefit for-mula is designed to give lower-income workersmore for their Social Security taxes than higher-income workers. If a government worker spent 30years in a job not covered by Social Security andonly 12 years in one that is covered, his or her

Social Security earnings record (AIME) wouldappear to be very low when compared to his or heractual average income including both jobs. This isbecause all of the income not covered by SocialSecurity would be excluded from the AIME calcula-tion. Without this provision, a middle-income oreven upper-income worker would receive a low-income worker’s Social Security benefit.

The Dual Entitlement Rule. A long-standingprinciple of Social Security holds that a workercannot qualify for both full retirement benefits andfull spousal benefits. Accordingly, although a mar-ried worker theoretically qualifies for both retire-ment benefits from his or her own earnings recordand a spousal benefit equal to 50 percent of thespouse’s retirement benefit, the dual entitlementrule limits the spousal benefit.

The dual entitlement rule reduces the spousalbenefit dollar for dollar by the amount of theretirement benefits for which a worker qualifiesunder his or her own earnings record. Thus, iftwo spouses each qualify for $1,200 per monthfrom their own earnings records and for spousalbenefits of $600 per month (one-half of the basicretirement benefit), they would still receive atotal benefit of only $2,400 ($1,200 per worker).Both spouses are ineligible for the $600 spousalbenefit because their individual retirement bene-fits are greater.

On the other hand, if one spouse received$1,200 per month and the other received $400per month from Social Security, the lower-earn-ing spouse would qualify for a $200 spousalbenefit. In this case, the $600 spousal benefitfrom the higher-earning spouse would bereduced by the lower-earning spouse’s benefit($600–$400), leaving a $200 spousal benefit.The dual entitlement rule potentially affects 96percent of the workforce.

Notch Babies. “Notch babies” are certain work-ers who were born between 1917 and 1921. Dueto a technical error in a 1972 law, they receiveslightly lower benefits than workers born beforethem, although they also receive slightly higherbenefits based on their earnings record than work-ers born after them. As a result, legislation has reg-

page 13

March 2, 2005No. 1827

ularly been introduced in Congress that wouldeither raise their benefits or provide them with alump-sum payment.

However, a 1994 commission found that,although they do receive slightly lower benefitsthan workers born before them, notch babiesreceive a fair return for their taxes. As a result, nolegislation concerning notch babies has beenpassed, and this situation is unlikely to change.

Notch babies get their name from a line graphshowing average benefits by age of birth. Becausethose born between 1917 and 1921 tend to receiveslightly lower benefits than those born beforethem, the line has a slight notch for those years.

The problem was caused in 1972 when benefitswere first indexed for inflation. Regrettably, Con-gress made a technical error in writing the law thatresulted in workers receiving a double adjustmentfor inflation. By the time Congress corrected thiserror in 1977, some workers had already retiredwith higher benefits than they should havereceived. Rather than lowering their benefits, Con-gress decided to correct the problem for only those

who had not yet retired. In addition, rather thanjust correcting the law to lower benefits to wherethey should have been, Congress phased in thechange over a five-year period, affecting retireesborn between 1917 to 1921.

ConclusionSocial Security is a remarkably complex pro-

gram, and few people actually understand how itoperates. In many cases, terms used by SocialSecurity (e.g., trust fund) have meanings that aredifferent from the meanings conveyed by thesame terms when they are used in the privatesector. However, if the current program’simpending financial problems are to be avoided,it becomes increasingly important for informedcitizens to measure different reform optionsagainst the existing program’s actual operatingstructure and practices.

—David C. John is Research Fellow in Social Secu-rity and Financial Institutions in the Thomas A. RoeInstitute for Economic Policy Studies at The HeritageFoundation.

page 14