Talking about inflation raises prices. Here's how financial advisors can address the "I" word

Consumers worry about high gas prices. With inflation, perception can become reality.
Consumers worry about high gas prices. With inflation, perception can become reality.

Everyone worries about too much inflation. But merely discussing it can make goods and services even more expensive and potentially disrupt retirement planning.

This dynamic, now center stage as consumer prices have ticked up rapidly each month since April 2021, puts wealth advisors between a rock and a hard place when it comes to walking worried clients through “the hidden tax.”

It’s called the psychology of inflation, and as detailed in research by economists and behavioral psychologists, it works like this: 

When consumers see prices rising, they turn negative and expect the trend to continue, in part because bad things tend to be processed more on an emotional level, while good things are absorbed more on a cognitive plane. So as prices spike, worried consumers rush to make big purchases, like houses and washing machines, because they think those items will cost more in the future. The increased demand causes manufacturers and importers to further boost their prices. 

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Meanwhile, because stuff costs more, employees demand higher pay. When they get it, their employers charge more for the goods and services they sell, because the cost of doing business has risen. Add in shortfalls induced by supply chain snarls, a COVID economy still struggling to recover, global economic damage from Russia’s invasion of Ukraine, a major commodities exporter, and a labor shortage fueled by the pandemic, and the fear of rising prices becomes a self-fulfilling reality.

It all means that advisors have to walk worried clients through what the erosion of purchasing power means for their daily expenses, splurges and nest eggs. At the same time, advisors don’t want to foster assumptions and spending behaviors that can crimp a client’s wallet even more.

“Economists are concerned that even talking about inflation drives it up,” said Lance Sherry, a lawyer and certified financial planner at wealth management firm Kovitz in Chicago. “But it’s out there, and it’s real.” 

It’s a version of the same conundrum that the nation’s central bank finds itself in. The Fed’s main role is to keep the natural phenomenon of inflation nominal and steady, using interest rates to shape borrowing and consumer spending. But when consumers have a different perception of how inflation is panning out, it can make that task tougher and inflation more stubborn. As Nancy Tengler, the CEO and chief investment officer of Laffer Tengler Investments in Nashville, Tennessee, said, the higher the rate of inflation, the more the Federal Reserve needs to raise interest rates, in turn increasing the possibility of a recession.

With investors asking their advisors what the highest consumer prices since 1981 mean for their retirement nest eggs, here’s how wealth planners are handling the “i” word.

The first thing Kovitz's Sherry does is walk his clients through the current and historical situations.

Consumer prices rose 8.6% in May from the same month a year ago, with housing, food and gas prices spiking the most, according to the Labor Department's most recent data. Whether a client is mass market or wealthy, they tend to look to the price at the pump as a proxy for the economy, and it’s ugly: an average 34.6% spike in energy prices last month has driven the cost of a gallon of gas near $6 or above in California, Illinois, Nevada and Oregon. 

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U.S. inflation varies widely by decade, from an average of around 8% each year over the 1970s, with some years in the double digits, to under 3% a year over 2000-2009, according to the National Bureau of Economic Research. Shelling out more at the pump makes people feel like they're spending more overall. It's a form of mental accounting in which people don’t consider all dollars to be the same, but instead bracket them (food here, retirement there) — a cognitive bias that can fuel bad spending decisions. 

The price spike has sent consumer sentiment to its lowest level since 1980, according to the University of Michigan’s most recent benchmark survey in June. Nearly half  (47%) of Americans blame inflation for eroding their standard of living. As the Fed aggressively raises interest rates in a bid to curtail prices by making credit-based spending more expensive, 44% of consumers surveyed expect the U.S. economy to dip into a recession next year, according to a CBS/YouGov poll conducted June 22-24.

All of which means advisors may have to pivot from talking about inflation to a significant decline in economic activity of at least a couple of months.

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Still, Jonathan Thomas, a private wealth advisor at LVW Advisors in Pittsford, New York, argued that “inflation shouldn’t change your investment strategy — it should be about adding things in the margins.” He said he likes short-term corporate bonds from Goldman Sachs and Citibank with returns over 3%.

Ken Van Leeuwen, the managing director of Van Leeuwen & Company in Princeton, New Jersey, said that amid higher prices, wealthy clients may not have to “preemptively” cut back on golf memberships or dining out, in part because he assumes for them a higher “normal” rate of inflation of 4%, twice the 2% target of the Fed. 

“This way, our clients are prepared to weather a spike in prices,” he said.

But if inflation psychology persists and prices continue to rise, it could dent his buffer. 

“Your retirement dreams can be put at considerable risk when you have a financial plan that doesn’t accurately factor in inflation,” Van Leeuwen said.

Mimi Duff, a senior client advisor at GenTrust, said that with inflation up and stocks down, “the current market is one of the most fertile investment landscapes we have seen in the past 10 years.” She cited highly rated 30-year municipal bonds with a 4.25% yield — the equivalent of a 7% pre-tax return.

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