Without question, Social Security benefits play an important role in retirement planning. Experts often cite the three-legged stool as the foundation of a retirement plan, with the legs of the stool consisting of Social Security, employer-sponsored retirement benefits and personal savings. For many people, Social Security benefits make up a large portion of the plan.

Knowing how your Social Security benefits are calculated is critical. Calculating these benefits can be complicated, but it’s certainly doable. The first step is to determine whether you are even entitled to retirement benefits in the first place.

To be fully insured, you must have accrued a certain number of credits. If you were born after Jan. 2, 1929, you need 40 credits to receive your full retirement benefits. The Commissioner of the Social Security Administration, or SSA, determines the amount of earnings that will equal a credit each year, and the bar is set pretty low.

In 2012, the amount of earnings required to earn a credit is $1,130. You may earn up to four credits per calendar year. “If you are self-employed, you earn Social Security credits the same way employees do,” says Alexey Bulankov, a CFP professional with McCarthy Asset Management Inc., a registered investment advisory firm based in Redwood Shores, Calif.

The “primary insurance amount,” or PIA, is the amount you should receive at your normal retirement age, which ranges from 65 to 67, depending on the year in which you were born.

The not-so-secret formula

The formula is based on the average indexed monthly earnings, or AIME, in the 35 highest-earning years after age 21 up to the Social Security wage base. In 2012, this ceiling is $110,100. “If a person works (fewer) than 35 years, missing years are filled in with zeros. If they have worked more than 35 years, only the highest-earning years will be considered,” says Charles C. Scott, president of Pelleton Capital Management Ltd. in Scottsdale, Ariz.

Bulankov says earnings from a worker’s 35 highest-earning years are tallied at age 62 and indexed for inflation, resulting in the AIME. The Social Security Administration determines the primary insurance amount, or PIA, by applying a PIA formula to the AIME.

The AIME is “divided into three segments, called bend points (which are adjusted each year for inflation), giving you the worker’s PIA,” says Scott.

For example, assume you have a 62-year-old born in 1950 whose total indexed earnings over his 35 highest-earning years were $2 million. The $2 million divided by 420 months gives the worker an AIME of $4,762.

The first bend point, $767 of the AIME, is multiplied by 90 percent. The difference between $767 and the second bend point of $4,624 ($3,857) is multiplied by 32 percent. The amount more than $4,624 ($138) is multiplied by 15 percent. These percentages and limits are set by the SSA.

So let’s apply this formula to find out what the Social Security benefit would be at full retirement age.

  • The first bend point gives you a benefit of $690.30 ($767 x 0.9 = $690.30).
  • The second bend point gives you a benefit of $1,234.24 ($3,857 x 0.32 = $1,234.24)
  • The third bend point gives you a benefit of $20.70 ($138 x 0.15 = $20.70).

The sum of all of these amounts is $1,945.24. Because amounts are rounded down to the next-lowest dime, this worker’s PIA, which is the amount the worker would receive at full retirement age (66), is $1,945.20.

Stay on top of your benefits

Certain factors can change the amount to which you are entitled, such as electing to receive benefits early or delaying retirement beyond the full retirement age. You would get a reduction in pay if you claimed benefits early, and you’d get an increase if you delayed claiming benefits up to age 70. Also, government workers receiving pension benefits may not be eligible to receive Social Security.

While the calculation can be complicated, knowing how your benefit is determined can help you with retirement planning.

In 2011, the Social Security Administration stopped mailing out the annual earnings statements around each worker’s birthday to save an estimated $70 million in postage and printing costs in 2012 alone. However, they will send earnings statements to those 60 and older, and will provide a one-time mailing to those who are 25.

If you are not scheduled to receive an update, you can estimate your benefits by using the Social Security Retirement Estimator.