What Are Indexed Earnings?
Indexed earnings is a calculation the Social Security Administration (SSA) uses to determine Social Security benefits by taking inflation into consideration. Inflation is the rate at which prices increase within an economy over a period of time. The amount someone collects from Social Security after retirement or disability after an injury is based on the wages made over a lifetime.
Key Takeaways
- Indexed earnings are used in the calculation of life-long wages when adjusting for inflation.
- The indexed earnings apply to the earnings prior to the two most recent years.
- Disability payment calculations take the 35 highest years of indexed earnings and divide them by the months worked in those years.
- Indexing earnings ensure receipts get paid fairly and equitably.
How Indexed Earnings Work
For Social Security purposes, wage indexing depends on the year in which a person is first eligible to receive benefits, and an individual’s earnings are indexed to the average wage two years prior to the year of first eligibility. For retirement, eligibility is at age 62. So if a person reaches age 62 in 2022, then 2022 is the person’s year of eligibility.
Following the same example, this person’s earnings would be indexed to the average wage index for 2020, which is 55,628.60. Earnings years before 2020 would be multiplied by the ratio of 55,628.60 to the average wage index for that year; earnings in 2020 or later would be taken at face value.
The amount in disability payments (SSDI) a person is eligible for is also based on average indexed monthly earnings. This is determined by taking the 35 highest years (prior to age 60) of indexed earnings and dividing that figure by the total number of months worked during those years.
Thus, if you worked every month, without fail, your average indexed monthly earnings would equal the sum of 35 years of work divided by 144 months.
Special Considerations
Making sure amounts are determined fairly and equitably for recipients of Social Security or disability is significant. Not factoring in inflation would have the effect of lowering the wages that the benefits are based on and would certainly impact someone’s quality of life. If inflation rises 2% per year, the price increases can add up over many years, which can eventually erode the value of Social Security benefits. A person might be forced to downsize from a larger home, cancel a planned vacation, or stop contributing to their grandchildren’s education.
Social Security benefits in the U.S. are calculated using average indexed monthly earnings, a type of indexed earnings. Indexing earnings allow the Social Security Administration to award benefits that account for changes in standard of living. If earnings were not indexed in this manner, then retirees would receive much lower benefits that would be out of proportion to the true buying power of their earnings in prior years.