Imagine that you are doing an annual review for a client who hasplanned long and well for retirement. This client is expecting toretire in five or six years.

As you go through the paperwork, everything clicks into place.If savings and performance stay on pace, this client should haveenough income from pensions, bonds, personal savings, IRAs, andSocial Security to live comfortably over a long retirement.

The client looks at your numbers, frowns and says: "You havebased all this planning on an assumption of 3% inflation. Mygreatest fear - what I lie awake worrying about - is that inflationwill be much higher."

"How much higher?" you ask.

"I'm worried that by the time I retire, gasoline will cost $12 agallon and bread will be $10 a loaf. I'm worried that rents, taxes,utilities, and health care costs will be at least double what theyare today."

What do you say to this client? More importantly,what can you do?

During a long era of moderate U.S. inflation, some financialadvisors have forgotten that inflation protection should be animportant planning objective. For many already-retired orsoon-to-retire clients, inflation protection may rank second orthird in importance, behind preservation of capital and currentincome.

Now, it's time to sharpen your skills in helping clientsunderstand the importance of inflation protection, and also inproviding anti-inflation strategies. In this article, we'll suggestways to identify inflation-sensitive clients and ideas foradjusting their asset allocations, so they can sleep better atnight.

Bernanke and Williams

Ben Bernanke and John Williams are two Baby Boomer economistswho could not be more different in their world views.

Bernanke is the Chairman of the Federal Reserve, the powerfulinsider who influences U.S. monetary policy more than any otherperson alive.

Williams is an outsider, a gadfly and perhaps a prophet shoutingin the economic wilderness. As publisher of the electronicnewsletter Shadow Government Statistics, he has spentdecades tracking inflationary forces in the U.S. economy and whathe views as the real rate of inflation.

Although Bernanke and Williams seem diametrically opposite inthinking, they are two of the best reasons to take clients'concerns over higher inflation seriously.

In a 2002 speech entitled Deflation: Making Sure It Doesn'tHappen Here, Bernanke established his bona fides as anactivist deflation-fighter. You can read the text of his speechhere:

• www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

To prevent deflation, Bernanke said, the Federal Reserve shouldtake such steps as greatly increasing the money supply, droppinginterest rates to 0%, buying securities to maintain low bondyields, depreciating the U.S. dollar and (if necessary) workingwith the U.S. Treasury to buy financial institutions withgovernment-issued debt. Perhaps the most telling quote fromBernanke's 2002 speech was this:

"The U.S. government has a technology, called a printing press(or today its electronic equivalent), that allows it to produce asmany dollars as it wishes at essentially no cost."

By the time a real threat of deflation came emerged in theglobal financial crisis of 2008, Bernanke had become Fed Chairman,and he wasted no time putting all points of "the Bernanke Doctrine"into action. Just as importantly, many other central banks aroundthe world bought into the Bernanke Doctrine, and government-runprinting presses began spinning madly all over the world, churningout new money at essentially no cost.

Meanwhile, John Williams keeps shadowing the Bernanke Doctrineand warning of its consequences. He believes the U.S. Governmenthas vastly underestimated inflation and unemployment for years, andthis has led to an exaggerated official measure of U.S. GrossDomestic Product (GDP). You can view his arguments and "alternatedata" here: http://www.shadowstats.com

You can read Williams' most recently published economicoverview, called Hyperinflation Special Report: www.shadowstats.com/article/hyperinflation.pdf

Williams argues that the U.S. economy is slowly moving into a"hyperinflationary Great Depression" which he defines as "the useof fiat currencies - currencies with no hard-asset backing such asgold - and the resulting massive printing of currency that theissuing authority need(s) to support its spending, when it did nothave the ability, otherwise, to raise enough money for itsperceived needs, through taxes or other means."

Although Williams' views may seem extreme to some, they serve asa counterbalance to Bernanke's public stance - that massive moneyprinting can be relatively painless and benign.

Williams argument is perhaps most compelling in documenting theU.S. Treasury's "Alternate Fiscal Deficit and Debt." For example,as of the end of Fiscal Year 2009 (09/30/09), the Treasury reporteda gross federal debt of $11.9 trillion and a fiscal year deficit of$1.4 trillion. Williams says the actual federal deficit in fiscal2009, using generally accepted accounting principles (GAAP) andincluding federal entitlements such as Social Security andMedicare, was $8.8 trillion. He estimates that total federalobligations are $74.6 trillion, more than five times total U.S.GDP.

Who are Inflation-Sensitive Clients?

Considered together, the Bernanke Doctrine and the WilliamsShadow show the potential for: 1) higher rates of inflation in thefuture; and also 2) a different type of inflation than the U.S. haspreviously experienced. Over the past century, the U.S. economy hashad three multi-year periods of high inflation, summarized in thetable below.

In each period, the main inflationary pressure was produced byhigher prices - due to increased consumption and/or scarcity ofgoods and services - not massive money printing. In none of thesethree periods was the Federal Reserve as powerful as it has becometoday. In the first two eras, the U.S. dollar was totally orpartially backed by gold, which greatly constrained the Fed'soptions.

Here is an interesting observation made recently by RodrigueTremblay, a distinguished Candian economist:

"At the end of 2009, reflecting a binge of printing new money bythe Fed, the U.S. monetary base, i.e., money circulating throughthe public and banking reserves on deposit with the FederalReserve, stood at more than $2,016,136,000,000, after havingincreased 146 percent in three years. This is unprecedented."

You can read Professor Tremblay's recent paper, Economy USA2010: From the Scandalous Past to the Uncertain Future,here:

• http://onlinejournal.com/artman/publish/article_5438.shtml

How to Identify Inflation-sensitive Clients

Here are ideas for identifying clients for whom inflationprotection may be among the more important planning objectives:

• Retired clients living on fixed income sources - pensions,annuities and long-term bond interest - would be vulnerable to anysustained period of higher inflation.
• The longer clients expect to live in retirement, the morevulnerable they may be. For example, a female client in good healthwho retires at age 60 can expect to live another 25 years ormore.
• If John Williams' prognosis proves partially true, it may meanthat Social Security benefits will be whittled back for high-incomeretired people. Because these benefits currently areinflation-adjusted annually, dollar-for-dollar with CPI inflation,the U.S. government can't easily print its way out of massivefuture Social Security debts. Most likely, benefits will be"income-related" at some point in the future, as Medicare Part Bpremiums already are.
• Because the Consumer Price Index (CPI) is created and publishedby the U.S. government, it can be changed by the government. JohnWilliams argues that the CPI has been revised since the 1990s sothat it consistently understates true inflation. Clients who dependon CPI-adjusted income sources for retirement income may bedisappointed, because their actual expenses could rise much fasterthan reported CPI inflation.
• Clients who rent their homes are more vulnerable than clientswho own their own homes, because rental costs could risesignificantly in a high-inflation environment. Clients who haveadjustable mortgages could be more vulnerable than clients withfixed-rate mortgages.
• Clients who have adequate liquidity could be in better shapethan clients with their money tied up, due to the potential toinvest liquid assets at higher interest rates in an inflationaryworld.
• Inflation-sensitivity can be defined by clients' beliefs andvalues, in addition to their assets or incomes. Clients who arefiscally prudent themselves may be more worried about Bernanke'smoney printing machine. Ultimately, the success of the BernankeDoctrine depends on a U.S. economy that is strong enough to growits way out of financial holes and repay massive liabilities.Clients who are somewhat pessimistic about the economy may be moreinflation-sensitive than those who are optimistic.
• In annual reviews or interim communications, try to determinehow closely clients track increases in personal costs-of-living.Because most people tend to fill their cars' gas tanks, you can usecurrent trends in gasoline prices to open these conversations. Hereis a good source for tracking gas price trends: http://gasbuddy.com.
• Offer to help your clients track their investment performancein "real return" terms, after adjusting for CPI inflation. (Use themethod described in the box below.) Clients who take an interest inreal return data may have concerns about inflation.

Asset Allocation Adjustments for Inflation-sensitiveClients

Once you have identified clients who are inflation-sensitive,how might you help them adjust asset allocation? Let's assume thata client begins with a "traditional" asset allocation weighted 60%to stocks, 30% to bonds and 10% to cash. Here are ideas you maywant to discuss for adjusting this mix to protect purchasing powerover an extended period of high inflation.

Bonds

Long-term bonds are more vulnerable to high inflation than anyother asset class because interest rates rise with inflation. Overthe past 40 years, the correlation of 10-year Treasury yields withCPI Inflation has averaged about .60 to .70.

In the Bernanke Doctrine, an implicit reason for governmentmoney printing is to reduce the burdens of repaying large publicand private sector debts (and pension obligations) by inflatingthem away over time. This helps debtors (e.g., homeowners with30-year fixed-rate mortgages) and hurt long-term lenders (e.g.,holders of long-term bonds).

For inflation-sensitive clients, bond allocations could be paredback and shorter durations (2-4 years) could be emphasized.Long-term bonds with maturities of 10 years or more should beavoided. Long-term Treasury Inflation Protected Securities (TIPS)are vulnerable to price declines, and their inflation-adjustedprincipal and interest payments may only prove rewarding if clientsare prepared to hold them to maturity.

Cash/Money Market

For inflation-sensitive clients, there is bad news and good newsabout cash holdings. The bad news is that cash is likely to producenegative near-term real returns. Today's 1-2% yields on moneymarket instruments aren't attractive before inflation, and thepurchasing power of these yields will surely be negative ifinflation heats up.

The "good news" is shown in the graph below, which compareshigh-quality corporate bond yields, 1-year T-bill yields, and CPIinflation over the period 1960-2000.

For ideas on how to implement an inflation-adjusted asset classwith ETFs, see: ETFStrategies for a New Investment Era

To understand the diversification benefit of combining stocksand commodities in portfolios, see: TheNext Wave of Asset Allocation: Stocks and CommoditiesFutures

Summary

For the past two years, the "great debate" in the mainstreamfinancial media and blogosphere has focused on whether the nextphase for the U.S. economy will be deflationary or inflationary.But for purposes of guiding your clients and helping them achievegoals, this debate is a distraction - for two reasons:

1. Historically, deflation and inflation often have often been twosides of the same coin. From Weimar Germany to Zimbabwe, thedeflationary threats caused by loose money credit have driven theneed for high inflation to erase debts and liabilities, andultimately restore economic balance.
2. From his speech of eight years ago to the present, Ben Bernankehas been consistent in preaching a gospel of anti-deflation,supported by all the tools global central bankers have at theirdisposal. Over the past two years, Bernanke has consistentlypracticed what he preached.

There is no longer a doubt that printing press money will bepoured at the fires of deflation until it is doused for this cycle.The only questions are?what size flood will all this moneyultimately create?

And which of your clients will sink or swim init?