Definition Time: “Wage Indexing” and How it Works

Yesterday’s headline post on this site discussed a paper by AEI senior fellow Andy Biggs identifying “wage indexing” as a key culprit in Social Security’s long-term funding problem. As our post pointed out, wage indexing is the process of using the national average wage growth as a factor in calculating initial benefits. As a follow-up to yesterday’s discussion, we thought it would be helpful to provide a more detailed explanation of this somewhat esoteric term and its relationship to Social Security’s funding problem. So, here goes…

First, this thing called “AIME,” then the “PIA”

To calculate a retiree’s monthly benefits, Social Security determines their Primary Insurance Amount (PIA), the amount of the retiree’s benefit at their full retirement age. To determine the PIA, Social Security first looks at the retiree’s wage history and adjusts each year’s total earnings to account for wage inflation. From the wage-adjusted earnings history, Social Security then selects the highest 35 years of earnings, which are then totaled and divided by 420 (the number of months in 35 years) to determine the Average Indexed Monthly Earnings (AIME).

Developing the Benefit Amount

After the AIME is determined, Social Security applies three “bend-points” designed to add progressivity by ensuring lower earners receive a higher rate of replacement of their pre-retirement income. In 2025, retirees will earn 90% of the first $1,226 of their AIME, 32% of their AIME above $1,226 and below $7,391, and 15% of any portion of AIME over $7,391.[1]  These three amounts are then combined to form the PIA, or the initial benefit amount.

Social Security uses annual changes in the National Average Wage Index (NAWI) to adjust the bend points used in the PIA calculation each year. An alternative to using the wage index to adjust the bend points involves substituting the Consumer Price Index, a method known as price indexing. Using price indexing to adjust the bend points calls for each year’s new values to be adjusted based on the Consumer Price Index rather than the average wage index. Since prices tend to grow at a slower rate than wages, the bend points would also move in lesser increments, shifting more of AIME dollars out of the 90% calculation bracket and into the 32% and 15% benefit brackets. 

The net effect of this formula change would be a reduction in the initial benefit calculated for new retirees, with subsequent COLA adjustments also resulting in a lower appropriation of Social Security dollars.

Help is Available!

Yes, this can be a confusing topic. If you have any questions about this topic, or any other topics relating to Social Security, know that the AMAC Foundation provides a free-to-the-public Social Security Advisory Service designed to help you navigate the complexity of this major senior benefit program. Click here to learn more about this service and how to access it.


[1] https://www.ssa.gov/oact/cola/bendpoints.html

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