The Days Ahead:

  • Existing home sales but also a short week for the Thanksgiving holiday.

This Week:

  • Social Security is in the news again.
  • There are some easy fixes.
  • No, it’s not insolvent and nor will it be.
  • All those Teslas need new and bigger utility poles.
  • So does the Inflation Reduction Act infrastructure build out.
  • There’s a shortage of poles.
  • Inflation numbers were good.
  • We look at rent, health insurance and cars.

Program Note:

  • Happy Thanksgiving to everyone! We’ll be taking a break from the blog.

Social Security is in the News Again

Barely a week goes by without some alarm on Social Security. It’s usually along the lines of unaffordable entitlements, ballooning deficits, and urgent need for Social Security reform. It worries a lot of people such that 44% of Americans feel their Social Security will run out and 40% take their benefits before qualifying for full benefits just because they don’t think the money will be there in the future.

There are good reasons for delaying Social Security, not least because benefits increase 8% a year, before inflation, which is a decent guaranteed real rate of return. But these are people who fear the system will implode and want to get as much money out before the whole thing comes crashing down.

Just last week the well-named Fiscal Stability Act was proposed in the Senate to set up a commission to look at U.S. long-term fiscal spending and balances. There was no word about changing Social Security but it did mention “strengthening” it which was enough to get some people worried. To some that means either a benefit cut or a tax raise. Depending on what side you stand, either can be no-go areas. Senator Mitt Romney, who introduced the bill with Senator Manchin, said there would be no change for current retirees or people nearing retirement but that:

So far so reasonable, you would think. But the “Social Security Works” group said that Social Security  had nothing to do with the federal debt because it was self-funded, can’t borrow and only pays out what it receives in receipts. On the other side, the Committee for a Responsible Federal Budget thundered that Social Security faced insolvency and that the commission should consider all and any changes.

So, what’s the problem? Once a year the Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds (“Trustees”) put out a thumping 250-page report on Social Security. Social Security is set up as a trust fund, hence the Trustees.

We’re going to ignore the disability part right now. It pays out around $140 billion of the $1,144 billion of both the disability and old age programs but its revenues nearly always exceed benefits. It’s not a problem. Anything we discuss from here is about the retirement income part of Social Security.

We also hear that Social Security “is ten years from insolvency”. This is incorrect. Insolvency is an inability to repay debts. Social Security has no debt. Even if its asset portfolio depletes, it will still pay benefits from current tax receipts. The Social Security Administration has a unique definition of solvency which gets confusing. But to talk about “insolvency” is alarmist.

On the face of it, Social Security should be fine. It’s one of the few departments of government which has what is close to a hypothecated tax, meaning whatever money it raises is for Social Security only and can’t be used to buy a jet or build a bridge somewhere. Social Security was always meant to be separated from normal government budget negotiations and not subject to continuing resolutions. It’s one reason, when you look at the Monthly Treasury Statement, you’ll see that $1,207 billion of the $1,712 billion in Social Security receipts is “off budget.” In practice, it means any surplus, which it runs today, can’t be siphoned off into other parts of the government. It is literally “off” limits and not part of the budget.

Over the years, Social Security took in more than it paid and built up a reserve. That reserve now stands at $2,700 billion in assets. It also receives around $840 billion in income and pays out $993 billion. The shortfall comes from selling part of the reserve assets.

But it’s a classic actuarial problem that any life insurance company solves daily. The revenues come in based on payroll taxes. The insurance company would call this “premium” and would charge depending on age and health.

Whatever isn’t used to pay current benefits (either in the form of death benefits or income in the insurance world) you stick into an investment fund. Between your revenues (premiums) and investment income, you should be able to pay all the benefits on time and in full. It’s not that complicated, which is why life insurance is only a 6% return on equity business in a good year.

The basic concept for Social Security is the same. Revenues come in based on people working and the taxes they pay. Benefits are paid when those people stop working. But Social Security has a few more problems.

  • People are living longer.
  • They’re not having as many children, so there are fewer people entering the workforce, so less revenue.
  • Immigration is down, better than 2020 and 2021 but it means the workforce isn’t growing as much as it used to.
  • Average earnings haven’t risen in real terms by much, but…
  • Benefits are inflation adjusted.
  • The dependency ratio, which measures the number of working to retired people, was 5.2 times in 1970, slipped to 4.5 in 2010, then to 3.4 in 2021 and will probably be 2.8 in 2030.
  • Or another way to think about it is that the retired population grew 60% to 56.6 million in the 20 years to 2021…
  • But the 20 to 64 age group grew 14% to 194 million.
  • And the number of people employed grew 18% to 156 million.
  • Investment income on the asset portfolio is down.
  • And, most important, the Social Security Administration can’t raise taxes or income.  

The folk over at Social Security know all this and it’s in the big report. They put all the scenarios and assumptions together and come up with a high and low-cost scenario. In the high-cost scenario, the old-age-part of Social Security depletes its investment portfolio in 2035 and so must pay all benefits out of current taxes. Under the low-cost scenario, the date is postponed by five years to 2038. Again, the disability part never runs out of money, which is great. One less thing.

What happens over at Social Security in 2035, however, is a 25% across the board cut in benefits. It gets even messier. Under the Social Security Act, beneficiaries are fully entitled to their benefits. But under the Antideficiency Act, the government can’t spend anything “in excess of the amount [funds] available.” So, rock meets hard place. And there are 64 million people receiving Social Security, so this gets a lot of attention.

It all sounds very dire but there are policy solutions that would put Social Security on a quick road to postpone the 2035 date for around 100 years. Here’s what the American Academy of Actuaries came up with:

Graph showing how much of the shortfall would be recovered for each reform.
Source: American Academy of Actuaries, Cerity Partners

The bars show how much of the shortfall would be recovered for each suggestion. If you’re at 100%, you’re all done. Social Security goes on for another 100 years. Here are some of the solutions.

Raise the current FICA tax by 1.5%. The current tax is 6.2% for both employer and employee. If the rate increased to 7.75%, Social Security receipts would grow to $2,100 billion from $1,712 billion, and the program is fully funded. And it’s not all at once. Just a 0.1% increase per year until 2035 would do the trick. If the tax rate remains unchanged it would have to jump to 8.24% in 2035, just to meet the then obligations. You could also raise the Earned Income Tax Credit, which is a credit for those earning between $17,000 and $63,000 so that the tax increase by-passed the lower paid.

Tax all earnings. Right now, no one pays the Social Security tax rate once annual earnings reach $160,200. That means the maximum that an individual contributes in a year is around $10,453. The limit changes each year and is pegged to the Average Wage Index. But once you’ve earned $160,200, you pay no more into Social Security. 

A quick thought experiment: if the limits didn’t change, a worker who pays the maximum for 40 years would pay $418,000. If the same person were to take their Social Security benefit at age 70, they would currently receive $4,700 a month. If they lived for 20 years, they’d receive total benefits of $1,128,000. Which is a nice return. A deal like that would probably send our life insurance company mentioned above into default. Again, phasing in the tax in 1% increments would do the same job but without a sudden hit.

This measure would only affect the top quintile of wage earners and would cost around $6,700 for a household earning $270,000. It’s also exactly how Medicare benefits are taxed. They’re not subject to income limits. The policy would solve 78% of the shortfall.

Too much? Ok, tax only those earning more than $400,000, which is around 1.8% of all earners. You could also extend the taxable maximum to 90% of all earnings. Today around 83% of earnings is covered by Social Security. Changing both would cost around $14,800 for those earning $400,000. If both measures were introduced, they would cover 91% of the shortfall by 2035.

Taxing investment income, estates and carried interest. Yes, the old carried interest tax comes into play. We won’t go into its pros and cons but would just mention that if this sort of income was taxed for Social Security, it would solve 64% of the shortfall (we broke them out in the chart above).

Benefit adjustments. The Congressional Budget Office (CBO) also floated a number of ideas to change the replacement rate formulas, means testing, and limit inflation indexing for those receiving maximum benefits. It also suggests using a different inflation measure. The current one is the CPI that we all hear and read about but there’s something called the chained-CPI. It’s thought to be a lower, and more accurate, measure of the change in inflation but it’s subject to revision, which would make the indexing of benefits and taxes messy. Together these would provide about 23% of the shortfall.

Note that none of the above involve raising the retirement age. It’s a very hot button but would only solve around 3% of the problem.

Anyway, most of these ideas aren’t new. The CBO regularly publishes a report called the “Summary of Provisions That Would Change the Social Security Program”. Similar discussions happened many years ago. We’d summarize it as:

First, the 2035 “insolvency” date is when the trust fund runs out. After that, the only funds available to pay benefits will be from the Social Security taxes raised. Benefits will still be paid. But at a 76%, not 100%, level. So, if you hear “insolvency coming in 2035”, you can smile knowingly to yourself.

Second, the above changes aren’t complicated or original. They mostly involved new revenues which, we admit, are not the easiest thing to pass in Congress and aren’t really vote winner policies. But that doesn’t make Social Security a difficult problem. As (we think) Senator Moynihan said 30 years ago, a crisis is not a crisis if it can be solved with a 1.5% tax increase.

Third, spreading small changes over the next 13 years would seem to us less painful than cutting benefits or making big changes all at once.

Finally, we’d say that Social Security is not in imminent danger. But as any homeowner knows who’s just read an estimate for a new roof, some small expenses avoid a heck of a big problem later.

Electric Vehicles Need Trees

We’ve written a few times about the move to a more emissions friendly economy. It’s a fascinating evolution and there’s exciting new technology coming. In the past, we’ve discussed wind and solar and of course, uranium and electric vehicles. What’s fascinating is how much the economy will need to change to meet emission and clean energy goals. And one of the many things that will change are utility poles.

Why? Well, the American Broadband Initiative (“Internet for All”), for example, wants to see a streamlined process to access federal lands for any broadband installation. Sometimes the fiber and wire infrastructure are buried, especially in dense areas, but they’re also carried on poles.

Utilities own lots of them but they can’t just hand over the poles to the broadband guys. They’ve got their own challenges, especially building grid capacity for higher electric use. Not just for electric vehicles (EV) but also for increased industrial use.

The U.S. produces around 4.2 trillion kilowatt hours (kWH) of electricity ayear. For scale, your house probably uses 25 kWh a day in winter. A complete conversion of internal combustion engine vehicles to EVs would require another 1 trillion kwh generation. That’s doable but it will take time. The best estimate is that all cars will be EVs by 2050. So, there’s a constant and higher level of growth in electric power.

Utilities also need to strengthen poles for more expected adverse weather. Stoms and hurricanes are growing more frequent and intense. That means poles fall down more often and need bigger and stronger replacements.

Cars also seem to be hitting utility poles more these days. They involve 65% of all fatal crashes and 15% of all crashes. The last time it was reported (a while ago), 250,000 poles were hit by cars every year.  There are also new safety standards, and thus new pole and new designs, published every five years or so. 

PG&E, one of six utility companies in California, owns 3 million poles and expects to replace 500,000 of them in the next 10 years. There are 180 million utility poles in the U.S. and they carry everything from electricity, to internet, cable and phone wires. They also need insulators and transformers. Most are 50 to 60 years old and the average life is around 30 years. So, you need to build a lot just to replace what’s rotting away and, then a lot more on top of that to keep up with the infrastructure and electric grid build out.

So, we need new poles, lots of them, for new electric and broadband capacity and for new uses and to protect the poles against increased bad weather and car drivers who seem inclined to crash into them.

The trouble with poles is that you have to grow them. There are steel utility poles, but they’re imported and there’s a 25% tariff on imported steel. A 40-foot steel pole costs around $4,500, weighs 450 pounds and carries 900 pounds of wires and boxes. Oh, and steel and electricity don’t mix well. A timber pole will cost around $700, weighs 800 pounds and can carry up to 3,700 pounds, depending on its classification.

You can use concrete poles but they carry less than wood poles, weigh more and have to be dug deeper into the ground. So, wood is the only option if you’re going for scale.

Utility companies like wood poles. They bend more easily than steel in high winds. They have low initial installation and life-cycle costs. They’re easy to service without heavy equipment. The industry has good supply chains so can react quickly if there’s a natural disaster. They’re good insulators. They have a good record of “mechanical impacts” meaning if a car crashes into one, it doesn’t damage the car or the pole as much as a steel pole. They’re easy to modify if you want to add more cables or change the hardware. Finally, wood poles have a lot of variability meaning a wood pole will sway more like a tree before it breaks. A steel pole will have very little flex before it snaps.

(More at the “10 Features Often Overlooked About the Extraordinary Wood Pole”, required reading if you need to recharge any flagging Thanksgiving dinner conversation).

The standard pole you see on the side of the road is a 40-foot Class-4 pole. They’re nearly all made from one of four types of pine. It can carry an average of 2,400 pounds of hardware or more if it’s reinforced as in our example above. Today utility companies want 45-foot Class-2 poles which carry 3,700 pounds. The difference between the two classes is strength and flexibility (those storms remember). The only way to make a Class-4 into a Class-2 is to use older and wider wood. Older wood means more rings and width, which means more strength.

The trouble is, there aren’t enough of these older trees. There are a couple of public companies that specialize in the pressurized wood business, which covers rail road ties, residential lumber and utility poles. They typically source wood either from forest tenures (i.e. harvest rights), which are often government owned, or from timber farms or private land owners. The average pine tree takes 30 years to grow big enough for Class-4 pole use. A Class-2 pine will take another 5 years. High and wide trees are harder to find and often require a lot of searching to locate, fell and transport than smaller, narrower trees and so are more expensive. In a typical forest or farm, only 5% of trees can be made into poles.

Demand is high however and Stella Jones, a company with a big utility business, recently reported a 17% increase in sales of utility poles and increased profits by 62%. Historically, its margins were around 14% but are now over 20%. This is its share price this year, up 164% from a year ago.

Graph showing Stella Jones, a company with a big utility business, recently reported a 17% increase in sales of utility poles and increased profits by 62%
Source: FactSet, 11/15/23

The chart below shows growth in the utility construction sector, which has outstripped general employment growth, has an unemployment rate half the national average and seen average wages jump 15% in the last two years.

Graph showing growth in the utility construction sector
Source: FactSet, 11/15/23

The blue line is the number of utility construction workers and the green line is the percentage of total employment. They’re not all employed installing wooden poles but there’s a general shortage of workers who can do this type of farming, harvesting, processing, transportation and installation of wooden poles.

Lots of poles, not enough workers.

How’s this going to end? As we mentioned, the demand for infrastructure and transmission upgrades continues. It’s not about to end. Some substitutes may arrive for wooden poles such as composite materials and more steel but right now they’re not available. So, for the next few years, expect continued supply issues in this small, but important part of the energy transformation industry. It was never going to be easy being green. It’s a secular trend that will run for years. The wooden pole problems remind us that there will be cyclical problems along the way.

Those Inflation Numbers

The market liked the inflation numbers that came out on Tuesday. The Fed, after all, has been on about inflation for nearly two years since they discovered it wasn’t transitory in late 2022 when it peaked at 9%. The latest numbers are 3.2% for the headline CPI and 4% for the core CPI. The three-month moving average for the core-CPI is 0.3% and the All-Items Less Food and Shelter, for those that don’t live anywhere or eat anything, the annual rate is 1.0%. Actually, that number isn’t as nonsensical as it sounds. It tries to adjust out volatile food prices and the lag effect of rent increases.

We’ll pick out three trends.

One is rent inflation. As we’ve discussed before, rent inflation lags the rest of the CPI because the Bureau of Labor Statistics (BLS) only surveys every household twice a year. Also, the BLS measures average rents not new rents. New rents go up. Old rents do not. So, it takes a while for all those new rents to end up in the numbers. That’s how you end up with a chart like this, which is general inflation less rent and rent on its own. The rent line (green) lags general inflation (blue) by about a year.

Graph showing general inflation less rent and rent on its own.
Source: FactSet, 11/15/23

It’s still up 6.8% on the year but up only 0.3% on a monthly basis. It should continue to drop.

Two, our old friend health insurance. The BLS measures health insurance unlike anyone living in the U.S. will experience. It uses health insurance company retained earnings from the prior year. If retained earnings go up, the BLS assumes premiums went up and marks it down as a price increase for consumers. If retained earnings go down, it assumes prices went down. The health insurance companies released their 2022 earnings a few weeks ago. Retained earnings rose 29%. The year before they went down 17%. So, the BLS will now average that 29% gain for the next 12 months and remove the 17% drop we’ve had for the last 12 months.

Graph showing CPI for Health Insurance.
Source: FactSet, 11/15/23

You can see the blue line dropped quickly in October 2022, trundled down at around -4% per month all year and now popped up to +1.1%. It’s not too much of a worry for the CPI because it carries only a 0.7% weighting in the core-CPI but it is higher in the PCE inflation measure, which is what the Fed uses. Either way, it should not be a major concern for the Fed.

Three, new and used vehicle prices are coming back down to earth. Both saw big increases following Covid-19 reopenings as car rental companies scrambled to buy back fleets they’d sold the year before and manufacturers re-opened after almost complete closure. The supply problem also clashed with demand which went up as more people worked from home and gave up on public transport.

Graph showing new vehicle prices were growing 10% for over a year and only recently have we seen a drop in prices.
Source: FactSet, 11/15/23

New vehicle prices were growing 10% for over a year and only recently have we seen a drop in prices (green line). Last month, prices were down 1.9% from a year ago. Used car prices fell even more, by 7%.

The supply issues with vehicles are mostly resolved and we don’t expect the recent UAW stoppages to contribute to any problems. Used and new car prices are around 8% of the core CPI and 25% of the “super core” inflation index which is services, less energy and rent. We wouldn’t mention it except that the Fed believes it’s a proxy for wages so they’ve discussed it a few times in the last few months.

We liked the inflation numbers and so did the market. The 10-year Treasury yield fell 0.2% to 4.4%, stocks were up 2.7% for the week and small cap stocks up 5.3%.

If the inflation numbers continue like this, the Fed will surely not need to hike again.

The Bottom Line

The better consumer and producer inflation number gave the market what it was looking for: a slowdown that would keep the Fed from over tightening but not enough to send the economy into imminent recession.

Retail sales told the same story. They were down but not so much to fear that the consumer is getting worried. Spending at gasoline stations, which is about 8% of all sales, was flat. We’d expect those numbers to dip next month because the Census Bureau measures gasoline supply data from refiners, not gas stations. So, the recent dip in gas prices should show up next month.

It’s been a wild ride on the 10-year Treasury with yields ranging from 4.4% to 4.6% almost daily. Remember a few weeks ago they were at 5.0%.

Stocks have held up well with the S&P 500 up 3.4% and 2.5% off their 52-week high set in July. Small caps seemed to do some catch up, rising 5% on the week but still 22% below their high over two and half years ago.

We’re entering the final rounds of trading for the year. We’d expect thin volumes and portfolio positioning. Year end rallies are very frequent and we’d expect this year to be no different.

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Art: Stephanie Holman (b. 1967)

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