Indexation is a system or technique used by organizations or governments to connect prices and asset values to inflation. This is done by linking adjustments made to the value of a good, service or another metric, to a predetermined index. Indexation requires the identification of a price index and whether a linking the value to the price index, will accomplish the organization's goals. Indexation is most commonly used with wages in a high inflation environment.
Breaking down Indexation
Businesses may use indexation to match an employee's salary to the inflation rate, meaning that an increase in the inflation rate over a period of time will lead to an increase in salary. This particular type of indexation is called a cost of living increase (COLA). Indexation is a pre-specified process, meaning that all parties involved are typically aware of how the link works.
In the above example, the use of indexation, in theory, can mitigate the impact of inflation against a workers salary. This way, jobs, and career paths remain relevant and in stride with fluctuations of overall inflation. There are still possibilities for economic changes to force some disparity between salaries and the pace of inflation.
How Indexation Is Applied to Different Types of Assets and Payments
Governments might use indexation as a means of control over the economy as a way to potentially alleviate the negative effects inflation can have.
Various assets and values might be subject to indexation. Some countries might apply indexation on certain types of tax payments at varying periods. For instance, it might be applied to debt mutual funds that have been held for a certain minimum of time before being sold. In such a case, the original purchase price is adjusted for inflation when calculating long-term capital gains that will be taxed when those debt funds are sold. This can lead to a discount on taxes after the transaction for the seller of such assets.
Indexation might also be applied to pension funds to reassure participants that their assets will keep pace with inflation. That way, the value of those assets do not erode as time passes.
Life insurance companies might offer their clients policies that include terms for indexation, which may promise a payout that is adjusted for inflation. However, the premiums for such plans can be higher with annual increases. Such a product may raise concerns about consumers overspending on premiums, especially for periods when inflation is minimal and below the rate of increase charged for indexation.