I was curious about how an individual's Social Security benefit was calculated so I did some Googling. I think the results are quite interesting so I thought I would share my conclusions.
For a full rundown of how the benefits are calculated, you should check out
http://www.ssa.gov/oact/COLA/Benefits.html. This is Social Security Office of the Chief Actuary's website which is fantastic, just straight numbers and facts. However, I will give a summary.
1. First, you calculate the average indexed monthly earnings (AIME). This is calculated by first taking all of your previous years of income (subject to an per year income cap that changes yearly), adjusting them to the present day for inflation via a specified index. You then add the highest 35 years of this inflation adjusted income and divide by 420 (=35*12) to get your AIME.
2. Your monthly Social Security payment is you retire at full retirement age, called the Primary Insurance Amount (PIA), is calculated by a piecewise linear function of your AIME. For 2014, the PIA is the sum of
- 90% of the first $816 of your AIME
- 32% of the portion of AIME between $816 and $4917
- 15% of the portion of AIME above $4917
The values $816 and $4917 change annually for inflation, but the 90%, 32%, and 15% figures are set by statute.
The first thing to realize is that the Social Security tax paid on the 36th highest year of income and below don't increase your payment at all. Definitely a bad ROI there.
However, what is more interesting is what happens when you retire early. Say you have a 20 year career. Then, when they calculate the AIME they are averaging in 15 $0s. This obviously brings the AIME down. However, since the AIME is proportional to the amount you have paid into Social Security this isn't necessarily a bad thing. What is important is that the ratio of PIA to AIME goes up! The ratio of PAI to AIME is 0.9 for low AIME and decreases all the way to 0.3 for someone who had an income of at least the income cap in all 35 years.
The return that an individual gets from Social Security is based on 2 things, the ratio of PIA/AIME and lifespan. Given that lifespan isn't something we have much control over, it is clear that an individual with a higher PIA/AIME has a higher ROI. Thus, individual who retire early have a higher ROI from Social Security.