How Does Social Security Covered Compensation Work?
Learn how employer retirement plans use an average of Social Security wages to adjust benefit formulas, coordinating private savings with public benefits.
Social Security covered compensation is a figure used by some employer-sponsored retirement plans to coordinate with government-provided Social Security benefits. It represents an average of historical Social Security earnings limits and is used to structure plan contributions or benefits. This allows plans to provide different levels of support based on whether earnings are above or below this specific threshold. Understanding this concept helps employees comprehend the design of their company’s plan.
Defining and Determining Covered Compensation
Social Security covered compensation is a specific figure calculated by averaging the Social Security taxable wage bases for the 35-year period ending in the year an individual reaches their Social Security retirement age. The taxable wage base is the maximum amount of annual earnings on which Social Security taxes are collected. An employee’s covered compensation amount is unique to them, as it is based on their specific year of birth and corresponding Social Security retirement age.
Because the calculation is complex, individuals and plan sponsors do not perform it themselves. Instead, the Internal Revenue Service (IRS) publishes annual tables that provide the covered compensation amounts. These tables list amounts for each year of birth, sometimes providing a rounded figure that groups several birth years together for administrative ease.
A person’s covered compensation amount remains the same for any plan year before their 35-year measurement period is complete. Once an individual reaches their Social Security retirement age, their covered compensation amount becomes fixed and no longer changes with annual adjustments to the taxable wage base. Plan sponsors rely on these official IRS tables to administer their retirement plans correctly and ensure compliance with federal regulations.
The Role of Covered Compensation in Retirement Plans
The function of covered compensation in retirement plan design is to enable a feature known as “permitted disparity,” also commonly referred to as Social Security integration. This allows a retirement plan to provide a higher rate of contributions or benefits for employee earnings above a specified “integration level,” which is often the employee’s covered compensation amount.
The logic behind these rules is that Social Security benefits are weighted to replace a higher percentage of income for lower-paid workers than for higher-paid ones. Permitted disparity rules allow employer plans to provide a greater benefit on compensation that is not covered by Social Security. This helps to equalize the total retirement benefits from all sources as a percentage of pay across all income levels.
By integrating with covered compensation, a plan can legally provide a higher benefit to more highly compensated employees without violating general nondiscrimination rules. These rules are in place to ensure a plan does not unfairly favor a company’s owners or highest-paid employees over the rank-and-file workforce.
Application in Defined Contribution Plans
In defined contribution plans, such as 401(k) and profit-sharing plans, permitted disparity allows for a two-tiered contribution formula. The plan specifies a “base contribution percentage” that applies to all of an employee’s compensation and an “excess contribution percentage” on compensation earned above the plan’s integration level.
The excess contribution percentage may not be more than double the base contribution percentage. The difference between the excess and base percentages cannot be more than the lesser of the base contribution percentage or 5.7%.
For example, a profit-sharing plan might contribute 4% of total pay for all employees (the base percentage) and 8% on pay above the covered compensation level (the excess percentage). An employee earning $150,000 with a covered compensation of $100,000 would receive a contribution of $4,000 on the first $100,000 (4%) plus $4,000 on the next $50,000 (8%). This formula is compliant because the 8% excess rate is not more than double the 4% base rate, and the 4% difference is less than 5.7%.
Application in Defined Benefit Plans
In defined benefit pension plans, covered compensation is applied to the benefit formula rather than the annual contribution. This is conceptually similar to its use in defined contribution plans, allowing the formula to provide a higher rate of benefit accrual on earnings above the covered compensation level.
A common formula structure is an “excess plan,” which specifies a base benefit percentage for earnings up to an employee’s covered compensation and a higher excess benefit percentage for earnings above that level. For instance, a plan might provide a benefit of 1% of an employee’s final average pay up to their covered compensation, plus 1.65% of their final average pay above that amount, for each year of service.
The disparity limits for defined benefit plans are also regulated. The benefit percentage for earnings above the covered compensation level cannot be more than double the percentage for earnings below it. Additionally, the spread between the two percentages cannot exceed 0.75% for any given year of service. These rules ensure the integration with Social Security provides a modest, rather than excessive, advantage for higher earners.