Most people—and certainly Social Security beneficiaries—understand the Trust Fund can only exist so long as there are working people funding the program through payroll taxes. And thanks to the pandemic, we’ve struggled with historic unemployment levels and massive wage loss nationwide. The payroll contributions Social Security relies on to pay retiree benefits didn’t disappear in 2020, but they took a serious hit.
The contribution loss in 2020 was great enough for Social Security’s Chief Actuaries to project we lost a year of program solvency.
But what we haven’t discussed is the impact COVID-19 could have on benefit amounts in the future. The pandemic has done more than just reduce Social Security’s solvency. It has created an economic reality that affects the formula we use to calculate benefits.
Something we don’t often talk about is the average wage index. The average wage index is a fundamental piece of the equation we use to determine how much an individual’s benefit check should be. It refers to an index created when we look at the average earnings of every worker in the country.
In the past when we’ve only looked at inflation rates to determine benefits, we’ve ended up with benefit amounts that vary wildly from year to year and can far exceed contributions being made to the Trust Fund. So to make sure benefits and contributions stay agreement AND that we account for years with significant inflation, we use both pieces of data to determine appropriate benefit amounts.
Here’s the problem:
What happens when out of the blue we have a year in which the average wage plummets?
To arrive at the average wage index, we divide total income by the number of total workers. The number we end up with is the raw wage.
The average wage index for the current year is determined by applying year-over-year raw wages to the previous year’s raw wages. Meaning this year’s average wage index will be partially determined by the raw wages of 2020. And next year’s average wage index will be influenced by 2021’s raw wages.
Here’s where it gets tricky: there were only a few months the number of workers decreased in 2020. But the wages of those workers remain very low due to closures, pay cuts, and loss of hours. When we divide a significantly lower amount of total income by an overall unchanged amount of workers? The raw wages we get are LOW. This creates a low average wage index, estimated in 2020 to be between 5.9-10% lower than in 2019.
When the average wage index is down, it can reduce benefit amounts.
While benefit amounts are locked in for those who have already retired, this could impact those turning 62 in 2022. If the 5.9% average wage index reduction estimate holds true, this could mean an average wage worker retiring in 2022 could lose $120 in monthly benefits.
Financial planner Devin Carroll breaks down the average wage index, how it’s calculated, and just how in the world one uniquely bad year can turn Social Security calculations upside down in the video below.