Imagine that you are doing an annual review for a client who has planned long and well for retirement. This client is expecting to retire 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 have enough income from pensions, bonds, personal savings, IRAs, and Social Security to live comfortably over a long retirement.

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

"How much higher?" you ask.

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

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

During a long era of moderate U.S. inflation, some financial advisors have forgotten that inflation protection should be an important planning objective. For many already-retired or soon-to-retire clients, inflation protection may rank second or third in importance, behind preservation of capital and current income.

Now, it's time to sharpen your skills in helping clients understand the importance of inflation protection, and also in providing anti-inflation strategies. In this article, we'll suggest ways to identify inflation-sensitive clients and ideas for adjusting their asset allocations, so they can sleep better at night.

Bernanke and Williams

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

Bernanke is the Chairman of the Federal Reserve, the powerful insider who influences U.S. monetary policy more than any other person alive.

Williams is an outsider, a gadfly and perhaps a prophet shouting in the economic wilderness. As publisher of the electronic newsletter Shadow Government Statistics, he has spent decades tracking inflationary forces in the U.S. economy and what he views as the real rate of inflation.

Although Bernanke and Williams seem diametrically opposite in thinking, 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't Happen Here, Bernanke established his bona fides as an activist deflation-fighter. You can read the text of his speech here:

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

To prevent deflation, Bernanke said, the Federal Reserve should take such steps as greatly increasing the money supply, dropping interest rates to 0%, buying securities to maintain low bond yields, depreciating the U.S. dollar and (if necessary) working with the U.S. Treasury to buy financial institutions with government-issued debt. Perhaps the most telling quote from Bernanke'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 as many dollars as it wishes at essentially no cost."

By the time a real threat of deflation came emerged in the global 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 around the world bought into the Bernanke Doctrine, and government-run printing presses began spinning madly all over the world, churning out new money at essentially no cost.

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

You can read Williams' most recently published economic overview, 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 use of fiat currencies - currencies with no hard-asset backing such as gold - and the resulting massive printing of currency that the issuing authority need(s) to support its spending, when it did not have the ability, otherwise, to raise enough money for its perceived needs, through taxes or other means."

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

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

Who are Inflation-Sensitive Clients?

Considered together, the Bernanke Doctrine and the Williams Shadow show the potential for: 1) higher rates of inflation in the future; and also 2) a different type of inflation than the U.S. has previously experienced. Over the past century, the U.S. economy has had three multi-year periods of high inflation, summarized in the table below.

In each period, the main inflationary pressure was produced by higher prices - due to increased consumption and/or scarcity of goods and services - not massive money printing. In none of these three periods was the Federal Reserve as powerful as it has become today. In the first two eras, the U.S. dollar was totally or partially backed by gold, which greatly constrained the Fed's options.

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

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

You can read Professor Tremblay's recent paper, Economy USA 2010: 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 inflation protection 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 any sustained period of higher inflation.
• The longer clients expect to live in retirement, the more vulnerable they may be. For example, a female client in good health who retires at age 60 can expect to live another 25 years or more.
• If John Williams' prognosis proves partially true, it may mean that Social Security benefits will be whittled back for high-income retired people. Because these benefits currently are inflation-adjusted annually, dollar-for-dollar with CPI inflation, the U.S. government can't easily print its way out of massive future Social Security debts. Most likely, benefits will be "income-related" at some point in the future, as Medicare Part B premiums already are.
• Because the Consumer Price Index (CPI) is created and published by the U.S. government, it can be changed by the government. John Williams argues that the CPI has been revised since the 1990s so that it consistently understates true inflation. Clients who depend on CPI-adjusted income sources for retirement income may be disappointed, because their actual expenses could rise much faster than reported CPI inflation.
• Clients who rent their homes are more vulnerable than clients who own their own homes, because rental costs could rise significantly in a high-inflation environment. Clients who have adjustable mortgages could be more vulnerable than clients with fixed-rate mortgages.
• Clients who have adequate liquidity could be in better shape than clients with their money tied up, due to the potential to invest liquid assets at higher interest rates in an inflationary world.
• Inflation-sensitivity can be defined by clients' beliefs and values, in addition to their assets or incomes. Clients who are fiscally prudent themselves may be more worried about Bernanke's money printing machine. Ultimately, the success of the Bernanke Doctrine depends on a U.S. economy that is strong enough to grow its way out of financial holes and repay massive liabilities. Clients who are somewhat pessimistic about the economy may be more inflation-sensitive than those who are optimistic.
• In annual reviews or interim communications, try to determine how closely clients track increases in personal costs-of-living. Because most people tend to fill their cars' gas tanks, you can use current trends in gasoline prices to open these conversations. Here is a good source for tracking gas price trends: http://gasbuddy.com.
• Offer to help your clients track their investment performance in "real return" terms, after adjusting for CPI inflation. (Use the method described in the box below.) Clients who take an interest in real return data may have concerns about inflation.

Asset Allocation Adjustments for Inflation-sensitive Clients

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

Bonds

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

In the Bernanke Doctrine, an implicit reason for government money printing is to reduce the burdens of repaying large public and private sector debts (and pension obligations) by inflating them away over time. This helps debtors (e.g., homeowners with 30-year fixed-rate mortgages) and hurt long-term lenders (e.g., holders of long-term bonds).

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

Cash/Money Market

For inflation-sensitive clients, there is bad news and good news about cash holdings. The bad news is that cash is likely to produce negative near-term real returns. Today's 1-2% yields on money market instruments aren't attractive before inflation, and the purchasing power of these yields will surely be negative if inflation heats up.

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

For ideas on how to implement an inflation-adjusted asset class with ETFs, see: ETF Strategies for a New Investment Era

To understand the diversification benefit of combining stocks and commodities in portfolios, see: The Next Wave of Asset Allocation: Stocks and Commodities Futures

Summary

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

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

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

And which of your clients will sink or swim in it?