Is honesty really always the best policy? Or should you lie to save someone's feelings?

I generally go with the second option, like disagreeing with an overweight friend when she calls herself fat. My fiance, however, is on the other side. The most memorable example of this is when I admitted to him that after dating him I started to realize I wasn't as smart as everyone had always said I was. I'm average. He said something to the effect of that I'm pretty and he loves me, and at least I was smart enough to get into the college where we met. I was shocked and rather devastated for a couple days.

So, if someone close to you says something negative (but true) about themselves, how do you respond?