Chapter 17
Learning Objectives
(part 1 of 2)
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Describe the basic components of the
Social Security program
Compute the Social Security taxes for
any paycheck
Describe who qualifies for various Social
Security benefits
Compute a Social Security retirement
benefit
Learning Objectives
(part 2 of 2)
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Describe how a spouse's Social Security
retirement benefits are determined
Compare and contrast the two major
types of pension programs
Estimate a person's pension benefit
from each program
Explain why the PBGC is important to
people with DB pensions
Basic Components of the
Social Security Program
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Retirement Benefits
Disability Income Benefits
Survivor’s Benefits
Medicare
Social Security Taxes (1 of 2)
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Split between employer & employee
Self-employed folks pay both shares
Two aspects to the tax
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Maximum amount of income that is taxed
Marginal tax rate
Social Security Taxes (2 of 2)
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Employee pays 7.65% on first $84,900
in 2002, and 1.45% on all wage income
over $84,900
Example #1: Wage income = $40,000
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SS tax=$40,000x7.65%=$3,060
Example #2: Wage income = $100,000
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SS tax=$84,900x7.65%+$15,100x1.45%
= $6,713.80
Qualification for SS Benefits (1
of 2)
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Qualification based on quarters of
coverage
Maximum of 4 quarters credit per year
In 2002, need $870 of income in a
quarter for credit, or $3,480 in the year
for 4 quarters of credit
Qualification for SS Benefits (2
of 2)
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To qualify for retirement benefits, need
40 quarters of credit
To qualify for survivor’s benefits, 40 is
sufficient, but could be less
To qualify for disability benefits
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If younger than 24 => 6 quarters
If older than 61 => need 40 quarters
If in between, complex formula used
How to compute a SS
retirement benefit (1 of 4)
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Step 1: For each year worked,
determine the lesser of wage income or
income subject to retirement tax
Step 2: Multiply the income figure in
step 1 for each year by an index
number which adjusts the income for
that year for inflation
How to compute a SS
retirement benefit (2 of 4)
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Step 3: Sum the best 35 years of
income (use zeros if did not work at
least 35 years)
Step 4: Divide the sum in step 3 by 420
(# of months in 35 years). This
produces one’s average indexed
monthly earnings
How to compute a SS
retirement benefit (3 of 3)
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Step 5: Using the “bend points” for the
year of retirement, multiply the
components of the average indexed
monthly earnings by the marginal
replacement rates of 90%, 32%, and
15%
How to compute a SS
retirement benefit (3 of 4)
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Step 6: Sum the products in step 5 to
determine one’s primary insurance
amount (normal retirement income)
Step 7: Adjust the figure in Step 6 up or
down if a person retires before age 62
or after their normal retirement age
Step 8: After retirement, cost of living
adjustments applied each year
Spousal SS Retirement
Benefits
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Spouse of a retiring worker may claim
what he or she has earned in own
name
Or, spouse may claim one-half of
retiring worker’s benefit
If take the latter, then if retired worked
dies first, can step up to his or her full
check
Ex-spouses may also qualify
Pension plans: key features
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Qualified vs. non-qualified
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Qualified => contributions from an
employee’s paycheck are tax-deductible,
which means retirement income fully taxed
Non-qualified => employee’s contributions
are not deductible, so some of retirement
income is tax exempt
Vesting => an employee’s claim on the
employer’s contributions
Defined Benefit Pension
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Pension benefit based on a formula
Employee may contribute to
pension
Employer obligated to make sure
pension has enough cash to make
retirement payments
Example of DB Pension
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Employer pays 1.5% of “final average
salary” per year worked, for up to 30
years
Final average salary could be average
of last 5 years of employment
If “final avaerage salary” = $60,000, &
employee worked 30 years, annual
pension benefit = $27,000
Defined Contribution Pensions
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The amount contributed to the pension
each year is fixed by formula (e.g., 12%
of base salary)
Contribution could be split between
employer (e.g., 10%) and employee
(e.g., 2%)
Employee selects investment portfolio
Employee bears full investment risk
Example of DC Pension
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Employee works for 30 years at one
employer
Sum of employee’s and employer’s
contributions plus investment gains
provides an account of $1,000,000
At time of retirement, this would
provide an annual income of $80,000
Which is better: DB or DC?
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No simple answer as it depends on
details of the pension program
Employee has direct investment risk
with DC pension
Employee has indirect investment risk
with DB
Younger employees would generally
prefer DC, & older ones DB
Pension Benefit Guarantee
Corporation (PBGC)
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Government agency created under
ERISA act of 1974
Charges premiums to DB pension plans
If employer of DB plan fails, the PBGC
takes over responsibility for guarantee
of pension
PBGC has upper limits on pensions it
will pay