Inflation anxiety: Bridging the gap between a client’s fears and their financial plan

By Glenn Sanger-Hodgson

"Have you seen the price of eggs lately?!" your client asks, half jokingly.

It's a common refrain heard by financial planners everywhere, as inflation concerns grip the nation. With 63% of Americans viewing inflation as a major issue, according to Pew Research Center, clients are understandably anxious.

As financial planners, our role extends beyond just managing investments – we need to understand and address concerns like these. A key part is recognizing the behavioral biases that cloud our clients' perceptions of inflation, and finding ways to guide them towards more rational decision-making.

Availability bias

Has your client ever brought up a sensationalized news headline or viral social media post they had recently seen, and just wouldn’t let go? If so, this is an example of availability bias, a mental distortion that results from using the information that is most readily available, rather than information that is more representative.

Articles or social media posts like these often focus on the more volatile elements of the Consumer Price Index (CPI), like food and energy prices. After all, nothing drives clicks like complaining about high gas prices or large grocery bills!

But focusing on the elements of the CPI that are susceptible to factors like weather conditions or geopolitical events also creates a skewed perception of inflation.

To counter availability bias, planners should educate their clients by discussing different components that make up CPI. You may consider highlighting how core CPI excludes volatile food and energy prices and may be a better reflection of true inflation, or how the Personal Consumption Expenditures (PCE) index may be better yet.

This discussion can also lead to crafting a personalized inflation rate. By reviewing a client's specific spending habits, you can collaboratively arrive at a unique inflation rate for them that better reflects their lifestyle. For instance, a client who rarely drives might experience lower inflation than someone commuting long distances.

Financial planning software can then use this information, along with customized rates for high inflation categories like education and health care spending, to help tailor your projections for each individual client.

Anchoring bias

"I remember when gas was only a dollar a gallon! How will we ever afford retirement?" laments yet another client.

This illustrates the impact of anchoring bias on clients, which happens when they fixate on past prices for goods and services. However, this bias can also manifest in retired clients who anchor their spending in retirement to their initial withdrawal rate, even as growth in their portfolio more than supports a modest increase in spending.

Ultimately, these anchor points weigh heavily on our client’s view of current and future financial realities.

Advisors can help clients overcome rigid thinking by asking them to estimate low, medium, and high future living costs. The middle answer is right more often than not. This exercise also gives clients buy-in and helps them accept that spending needs to grow over time.

Planners should also counteract anchoring by breaking down a client’s portfolio. Stocks, Treasury Inflation-Protected Securities (TIPS), real estate and commodities like grains, energy and gold can all play a role. Advisors can help clients understand the pros and cons of each asset class in achieving long-term objectives while also safeguarding against inflation. By focusing on assets, and not income or expense, you can avoid the anchors that hold your client’s thinking in the past.

Recency bias

After inflation rates rose sharply, peaking at 9.1% in 2022, the Federal Reserve found that consumer perceptions of inflation remained elevated, even after rates came down. Just over a year after that peak, median perceived inflation by respondents was more than double the actual change in headline CPI.

This is recency bias at play, a tendency to overweight the information that was presented most recently. This bias often leads to erroneous beliefs that recent spikes in inflation will persist indefinitely, or that prolonged periods of low inflation, like that experienced between 2012-2019, will be the new normal.

To combat this tendency, planners should inform their clients about quality sources of inflation estimates. This includes looking at market-based indicators such as the 10-year breakeven inflation rate, and professional surveys like the Blue Chip Economic Indicators or the Federal Reserve Bank of Atlanta’s business inflation expectations survey, all of which provide for more accurate estimates expectations of households.

How we model inflation in financial plans can also play a role. Generally, planners model for inflation by employing static, long-term average inflation models. However, this doesn’t always match reality, as inflation's volatility introduces sequence-of-inflation risk, mirroring sequence-of-return risk seen in investments.

High inflation experienced early in one’s retirement can significantly deplete purchasing power in the long run. While simply increasing static inflation assumptions is tempting, this can lead to unnecessary over-saving and under-spending.

For financial planners who want to take a proactive approach, Monte Carlo simulations can model variable inflation in much the same way you might model investment returns. This approach provides a more realistic assessment of portfolio resilience, especially for clients with inflation-insensitive portfolios, such as those heavily invested in fixed income or relying on non-inflation-adjusted pensions or annuities.

Conclusion

In the face of inflation, financial planners play an important role, not only by constructing robust financial plans, but also by actively addressing the behavioral biases in our clients. Through education and deeply personal discussions, planners can empower clients to make better decisions.

This proactive approach enables clients to navigate uncertainty with confidence, ultimately solidifying the planner's role as a trusted advisor in an ever-evolving economic landscape.

Glenn Sanger-Hodgson, CSLP® is a financial planner at Shonan Gold Financial LLC, serving early-career professionals with student loans, such as physicians and lawyers, as well as business owners, real estate professionals and those with illiquid assets. He is also an adjunct instructor at Columbia College of Missouri and serves as the Treasurer for the Financial Planning Association of Florida.