As we touched upon earlier this month in our “Social Security 101” blog series, members of Colorado PERA, who comprise about 10 percent of all Coloradans, do not pay into Social Security while working for a PERA employer. Instead, they contribute a tax-deferred percentage of their pay to PERA’s retirement trust funds. Come retirement, they receive that money back in the form of a lifetime monthly income. (Yes, really.) It’s just one of the many benefits of working in public service here in Colorado.
As you might suspect, though, there’s a catch. In this case, it’s a little something called the Windfall Elimination Provision, or WEP. Allow us to explain.
You might recall from this earlier blog post that the Social Security Administration calculates your benefit by compiling your 35 highest-earning years, averaging them together, and dividing by 12. This produces your average indexed monthly earnings (AIME). That number is then applied to a three-part formula to determine your Primary Insurance Amount (PIA)—a.k.a., the monthly Social Security benefit you’ll receive at full retirement age.
To support lower-income individuals, this formula is designed so the PIA for lower-earning workers ends up being proportionally greater than that for higher-earning workers. Why? Social Security is by nature a social welfare and insurance program; it was established after the Great Depression to literally “secure” struggling individuals and their families against sinking into relative poverty.
Take the following example: We’ve got two workers, one whose AIME was calculated by the Social Security Administration to be $1,500, and the other whose AIME was calculated to be $4,000.
Both figures are applied to the same three-part formula, which for 2018 is:
- 90% of the first $885 in average indexed monthly earnings
- 32% of earnings between $885 and $5,397
- 15% of the remaining balance
As you can see, the PIA (or monthly Social Security benefit) for the lower-earning worker equates to 64% of his/her average earnings, while the PIA for the higher-earning worker equates to 44%.
Now consider a defined benefit plan like that which Colorado PERA offers—particularly one that serves as a replacement for Social Security (meaning its members contribute a portion of their earnings to the plan rather than to the Social Security system). Before the federal government established the WEP in 1983, the formula would calculate the Social Security benefit for these workers as if they were long-term, low-wage workers; in other words, they had the advantage of receiving a benefit that represented a higher percentage of their earnings, plus a payout from their pension. The WEP was designed to prevent individuals in this situation from receiving a "windfall" of Social Security benefits that weren’t proportional to the total income they actually earned.
Since Colorado PERA’s defined benefit plan is a replacement for Social Security, PERA members are subject to the WEP. If you couldn’t tell already, the concept is a bit of a monster to wrap your head around. Luckily, we put together a quick and dirty overview of how the provision could affect your Social Security benefit once you retire. (The silver lining? You might end up not having to worry about it at all.)
How the WEP works
Where the WEP comes into play is by reducing the 90% multiplying factor in the first part of the formula. How much it’s reduced depends on the number of years you had "substantial earnings" that were taxed by Social Security, but it’s possible that the multiplying factor could be as low as 40%.
According to the following chart from the Social Security Administration, the magic number for 2018 is $23,850. (These figures typically rise year over year according to rates of inflation.)
Here’s that silver lining we mentioned above: If you happen to have 30 or more years of substantial earnings, you’re not subject to the WEP. In other words, that 90% multiplying factor in the first part of the formula won’t be reduced.
For substantial earnings less than 30 years, however, here’s how the WEP shakes out:
The good news is that there’s a stipulation that protects you if the income from your pension ends up being too low. The WEP won’t reduce your Social Security benefit by more than half of your pension for any earnings on which you didn't pay into Social Security.
There you have it, folks: a high-level explanation of the WEP, and how it may (or may not) affect your Social Security benefit in retirement. As you’ll recall from our blog post last month on the “retirement stool” concept, this is yet another example of the importance of diversifying your approach to retirement savings. PERA members have a solid “leg” of retirement income to depend on thanks to their defined benefit plan, but it’s always a good idea to ensure that you’re not operating with a one-legged stool.
Interested in learning about how the WEP might affect you? Check out this calculator from the Social Security Administration.