Advisers and clients groaned when they learned the Social Security cost of living adjustments would be zero in 2016 — as they were in 2010 and 2011. But COLAs are not the only annual adjustment that can boost Social Security benefits. Some lesser-known ones can also be a boon for clients.
COLAs are based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), which has changed little year over year. But other Social Security features are adjusted based on a different metric, the National Average Wage Index. This index has been growing consistently year over year.
Each year, the Social Security Administration uniquely calculates NAWI based on all W2 reported wages subject to federal income taxes plus contributions to defined contribution plans such as 401(k)s.
Basic benefit calculations, disability insurance limits, and maximum family benefit are some of Social Security's features that depend on the NAWI for their annual adjustments.
The steady drumbeat of 0% COLAs can discourage clients, feeding into fatalistic worries about the Social Security system. It may cause them to claim benefits too early, feeling they need to get what’s theirs as soon possible and not make prudent Social Security choices.
By educating both themselves and clients about these non-COLA annual adjustments, advisers are better able to diffuse some of these tensions and keep clients on track with sound planning.
EARNINGS, WAGE GROWTH AND INFLATION
To understand the details of these annual adjustments, it’s important to start with some basics.
Social Security benefits are based on the highest 35 years of a client’s earnings that were subject to FICA payroll tax.
To adjust for inflation, each year of earnings is multiplied by a unique index factor assigned to that calendar year. This renders all earnings in current dollar terms.
These factors are generated by taking ratios of the current NAWI to the NAWI in the year being indexed. The index factors currently range from “1” for 2015 earnings, to “14.08” for 1955 earnings.
All of the index factors, for all years are, themselves, adjusted annually. NAWI annual adjustments for 2010 through 2014 were approximately 2.4%, 3.1%, 3.1%, 1.3%, and 3.6% higher than the previous year.
Even if there are no COLAs, your pre-retirement clients will still see their projected benefits grow, due to a rise in average wages in the US.
All indexing adjustments stop at age 62, the first year one is eligible to collect benefits. Any earnings after age 62 are averaged without any indexing.
Another annual adjustment is for bend points.
All 35 years are indexed earnings are then inserted into the benefit formula to determine the actual benefit that one collects at full retirement age (66 for most baby boomers).
The benefit formula contains factors called bend points that define three ranges of income. These are also adjusted annually based on the NAWI, typically increasing net benefits.
For example, between 2010 and 2014 the first point rose to $856 from $749. All income below this level is replaced at 90%. The second point rose to $5,157 from $4,517. An individual with an AIME of $5,000 would find their benefit increased by $144/month due just to these point adjustments. As long as wages keep rising, the points increase each year until age 62.
Other features that adjust annually based on the NAWI include:
Family Maximum — For Social Security beneficiaries with dependents, whether children or parents, there is a maximum benefit level that could be paid out to the entire family. This maximum is determined using three points that are similarly adjusted by the NAWI.
Quarter of Coverage — To qualify for benefits, one must accrue at least 40 quarters of earnings for which one pays FICA payroll tax. The minimum amount to qualify for a quarter of coverage is $1,260 for 2016. This regularly increases with the NAWI.
Substantial Gainful Activity — Social Security Disability Insurance establishes maximum amounts of monthly income which one can make and still qualify for these disability benefits. These maximums also increase based on the NAWI.
If your clients complain about low COLAs, point out some of these other benefits that continue to grow at a roughly 3% annual rate.