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The Windfall Reduction

What Is the Windfall Reduction?

The windfall reduction, enacted in 1983, reduces Social Security benefits for workers who have spent most of their careers working in government jobs not covered by Social Security, but who also qualify for a Social Security benefit based on 29 or fewer years in Social Security-covered employment. (Those who reached age 62 or became disabled before 1986 or who first became eligible for a pension based on non-Social Security-covered work before 1986 are not affected by the windfall reduction.)

Why the Windfall Reduction?

The Social Security benefit formula was designed to recognize that lower-income workers have less opportunity to provide for their retirement with savings and investments, and are less likely to have a substantial pension than middle- or higher-income workers. Thus the formula used to calculate a worker's initial Social Security benefit is "weighted" to favor the individual with a lifetime of low wages in Social Security-covered work. "Weighting" replaces a higher portion of the low-wage worker's preretirement earnings in benefits than it replaces for a higher-income worker.

Prior to enactment of the windfall reduction, this benefit formula had the unintended effect of treating a higher-wage worker with a few years of Social Security-covered work years the same way as a long-term, low-wage earner.

Social Security requires a minimum of 10 years (40 credits) of covered work to receive a benefit, but the benefit calculation is based upon averaging 35 years of wages. Thus, those with fewer years of Social Security-covered work at high wages -- when those wages are averaged over 35 years -- appear to have a lifetime of much lower earnings than was, in fact, the case.

The benefit calculation was designed to provide a higher replacement rate for workers who spent their lives in low-income jobs. It was not intended that higher-income workers who worked outside the Social Security system and earned pensions designed to work independently from Social Security should benefit from this weighting.

How Is a Social Security Benefit Calculated?

  • Average Indexed Monthly Earnings

Social Security benefits are calculated based upon the amount of a worker's lifetime average earnings that were subject to Social Security tax. The worker's 35 highest-earning years are adjusted to the value of today's wages and converted to a monthly amount called Average Indexed Monthly Earnings (AIME).

  • The Primary Insurance Amount

The benefit formula applies three progressive factors--90%, 32% and 15%--to specified portions of the AIME. The rates do not change from year to year, but the dollar amounts to which the rates are applied are adjusted annually based on changes in average wages. The resulting number is the Primary Insurance Amount (PIA). The worker's PIA is the amount from which all Social Security benefits based upon his/her earnings are computed.

(¶ Click here to see Lowering the 90% Factor Used in Calculating the Primary Insurance Amount (PIA) Eliminates the Unintended Benefit Windfall to Short-Term Higher Income Earners.)

Without the windfall reduction, the high-earning attorney who contributed to the Social Security system for only 10 years (see above -- Individual B Without Windfall Reduction) receives a monthly benefit that is more than $200 higher than the custodian who worked and contributed to the system for 35 years (see above -- Individual A).

With the windfall reduction ,the long-term, low-income earner benefits from the intended progressivity of the benefit formula. But the benefit of the short-term, high-income earner is reduced based upon the number of Social Security-covered work years (see above -- Individual B With Windfall Reduction).

 

Written by Laurel Beedon, Senior Policy Advisor, AARP Public Policy Institute
February 1998
© 1998 AARP
May be copied only for noncommercial purposes and with attribution; permission required for all other purposes.
Public Policy Institute, AARP, 601 E. Street, NW, Washington, DC 20049