Don't be fooled by Social Security benefits estimates

Donald Klaas, a financial adviser with Northwestern Mutual in St. Louis, sent me an important question the other day. He wrote that he has a 64-year-old client who has been a teacher at various schools during her career, including some that didn't pay into Social Security. Mr. Klaas wants to know if he can rely on the estimated benefits statements that his client has received from Social Security in the past to include in her retirement income planning calculations. In a word, no. Those who earned a pension from a job where the employer didn't withhold Social Security taxes from their salaries and who also worked in other jobs long enough to qualify for Social Security retirement benefits may be affected by the windfall elimination provision. The WEP rules affect how retirement or disability benefits are calculated and can result in a lower Social Security benefit. The WEP rules apply only to a worker's benefits. A separate rule — the government pension offset provision — applies to spousal and survivor benefits. The GPO can significantly reduce or even wipe out Social Security spousal or survivor benefits if the beneficiary also receives a pension from work not covered by Social Security. The WEP provision, on the other hand, can merely reduce the size of a worker's retirement benefit. The WEP reduction is limited to no more than one half the amount of the pension from employment that isn't covered by Social Security. For example if a pension is $500 per month, the WEP reduction couldn't exceed $250. To understand how the WEP rules are applied, it helps to know how Social Security calculates retirement benefits. The benefits are based on a worker's average monthly earnings adjusted for inflation. The average earnings are separated into three amounts, and then the appropriate factor is applied. For a worker who turns 62 this year, the first $791 of average monthly earnings is multiplied by 90%, the next $3,977 is multiplied by 32% and the remaining amount of earnings is multiplied by 15%. The sum of the three amounts equals the total monthly payment amount. For workers affected by the WEP rules, the 90% factor in the above calculation is reduced to 40%. For this year, the maximum reduction under the WEP formula is $395.50 per month ($791 x 90% = $711.90; $791 x 40% = $316.40; $711.90 - $316.4 = $395.50). However, it could be less. The WEP reductions aren't applied for those who have 30 years or more of "substantial" earnings in a job where they paid Social Security taxes. For this year, "substantial" earnings are defined as $21,075 or more. That figure increases each year. In 2000, substantial earnings were defined as $14,175 or more. For those who have 21 to 29 years of substantial earnings, the 90% factor is reduced to between 45% and 85%. Tables of the annual substantial earnings definitions and the reductions amount in the Social Security windfall elimination provision publication can be found at socialsecurity.gov/pubs/EN-05-10045.pdf. Individuals and advisers can also use the WEP online calculator at socialsecurity.gov/gpo-wep to estimate how much their benefits may be reduced. Remember, Social Security no longer mails benefit estimate statements to future retirees. Individuals must now set up personal online accounts at ssa.gov/myaccount to access their benefit estimates. Now that I have covered how WEP reductions are calculated, let's find out why they are. It is a matter of fairness, though those affected by the reductions may not see it that way. Social Security benefits are intended to replace only a percentage of a worker's pre-retirement earnings. The way that Social Security benefit amounts are figured, lower-paid workers get a higher return than highly paid workers. For example, lower-paid workers could get a Social Security benefit that equals about 55% of their pre-retirement earnings. The average replacement rate for highly paid workers is about 25%. Before the Social Security reforms of 1983, those who worked mainly in jobs not covered by Social Security had their benefits calculated as if they were long-term, low-wage workers. They had the advantage of receiving a Social Security benefit representing a higher percentage of their earnings, plus a pension from a job where they didn't pay Social Security taxes. Congress passed the WEP in 1983 to remove that advantage.