Real World Economics: Eliminating Social Security’s ‘windfall elimination’ would be an injustice

Consider the following situation: Two people are retiring. One worked entirely in a government job not covered by Social Security because it had a pension system of its own. The other worked entirely private-sector jobs requiring FICA.

You convert lifetime earnings of each to 2024-equivalent wages and you find both were solidly middle class, averaging $5,000 a month in 2024 dollars. The retirement benefit checks that each will receive are calculated.

But wait a minute! A last review of records shows that each actually averaged $6,000 a month over their working lives, not $5,000. As a result the monthly retirement checks of one rise by $900, but that of the other by only $320. In both cases the increase is in their Social Security benefit.

Is this fair?

Well, at least 62 members of the U.S. Senate think it isn’t. They don’t like current laws that allow for this differential and want to end the outcome described above.

Yes, the issue of “windfall elimination” for public employees is complicated, hard to explain and understand. Thus affected retirees feeling they are being mistreated are sincere. However, senators who demagogue the issue should know better. Their predecessors in 1983 clearly did.

The confusion stems from a collective lie we Americans tell ourselves and cling to like a holy cross. It is that Social Security is not “welfare” — not taking any money from some people and redistributing it to others. That would be “welfare” and should be scorned.

The lie that the majority of the population believes is that Social Security is only a mandatory savings program. We pay into it via FICA taxes on our wages and salaries. It earns interest. Then, at retirement, we “just get out own money back.”

Yes, many people, when pressed, do acknowledge that Social Security includes an insurance feature protecting those who become disabled or are survivors of covered workers.

But nearly everyone thinks retirement benefits are, or should be, the core of the program. We paid in, we should simply get back our own invested savings plus interest. Fortunately for a just society, that is not the case.

Here’s the real deal: Social Security was designed from its 1935 start to reduce poverty. Everyone would pay in and get out, but, to reduce absolute poverty, lower-income people would get more back relative to FICA taxes paid than higher-income payers. As one’s income goes up during working years, their benefits are adjusted down in retirement.

The “replacement ratio” of monthly benefits paid relative to average monthly earnings would be very high for a low starting income bracket. Then this ratio would taper off in two stages for higher earners. Everyone would get at least a basic living income when old.

Thus Social Security is, as designed, a program that redistributes income from higher-income households with to those with lower incomes. It is the largest income redistribution program in the history of civilization. Moreover, over half the population get more in benefits than the actuarial value — principal plus accrued earnings — that they put in. Some people rage when told that, but it is the truth.

In understanding all this, realize that methods for determining average earnings and formulas to calculate their related benefit amounts have changed several times since the benefits first were paid 85 years ago. So details of what happens now were not necessarily true in 1955 or 1975. For the last four decades, however, the system has been basically the same.

First a person’s lifetime annual covered earnings are listed by year. Then the dollar amount for each year is converted to current-year, i.e. 2024, equivalents using an index of how national wages increased over that time. For 2024, for example, earnings of $5,000 in 1964 would be multiplied by 14.5579418, the factor by which wages increased over 60 years. The result would be a 2024 sum of $70,790.

These wage-indexed current-year equivalents for one’s 35 highest-earning years are added up. This sum is divided by the total number of months to calculate “average indexed monthly earnings.” Understand that many different patterns of earnings, over time, could produce the same AIME.

For 2024, the actual monthly benefit paid starts with 90% of the first $1,226 of the person’s average indexed monthly earnings. Then 32% of any AIME between $1,226 up to $7,391 is added. For anything above $7,391, the addition to benefits is 15% of his/her average indexed monthly earnings up to $14,050, one-twelveth of the $168,600 taxed this year. For 2024, any yearly earnings above $168,600 is not taxed for FICA.

The result is a “primary” amount for someone retiring at age 67. Retiring from age 62, when benefits first become available, to age 67 gets one less per month, and waiting from 67 up to age 70 gets more. After 70, the amount one can receive does not go up.

This formula obviously does not give everyone exactly the same “return” on FICA dollars paid in.

In 1935, Congress wanted lower-earning people to have base minimum benefits approaching decent levels of living. After that, benefits would rise with FICA paid, but not in a constant proportion. After passing the first “bend point,” the overall “replacement ratio” of benefits to past average earnings would trend downward.

Setting aside protections for survivors and disability, typical old-age beneficiaries as a group in the 90% bracket get well more than FICA paid plus interest. Of course this varies by individual. And the top group above the 15% bend point gets less than the value of what they paid in. So the old age benefits of Social Security do redistribute income — substantial amounts of it.

And they should.

Yes, while most retired people feel better believing they are not getting money from anyone else’s taxes, and most working people prefer to believe that their FICA payments aren’t going to someone else, that simply isn’t true for many. As with private insurance policies, the premium paid in, plus the amount earned through interest and investment, is paid out to a different policyholder who has immediate needs. The drafters of the Act intended that low-income people get a greater proportional return than high-income ones even if it meant taking some of the money paid in my high earners.

That desire to use Social Security as a poverty reduction mechanism in addition to a mandatory savings vehicle leads to controversy over what rate of Social Security benefit public employees deserve on low-sum, private sector FICA-covered earnings.

If someone is getting, say, a public pension of $6,000 a month, does justice demand that they still get 90% of average FICA covered earnings just as a dishwasher or feed truck driver with no other pension does? Or should they get the 15% a private-sector earner with a $3,000 monthly benefit gets on their last dollars of historic earnings?

Most people who understood the issue in 1982 thought giving 90% to people who had high overall retirement benefits was unjust. With the broad 1983 reforms, great thought went into correcting this inequity. Unfortunately, it was called a “reduction” rather than an “adjustment” or “correction.”

Nevertheless, Congress passed the changes with large majorities in both parties in both houses. Democrats voted aye 163 to 54 in the House and 26 to 6 in the Senate. GOP aye votes were 80 to 48 in the House and 32 to 8 in the Senate. The only member of the 10-person Minnesota congressional delegation who voted no was GOP Rep. Arlen Stangeland from the rural 7th district in the western part of the state.

So a prudent Congress 40 years ago voted for fairness. But ever since demagogues have preyed on popular misunderstanding. The question today is whether their populism will defeat fairness.

St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.

Originally Published: December 22, 2024 at 9:01 AM CST