Inflation eats away at the value of money over time: €100 in 2020 will not buy the same basket of goods and services it buys now. To counter this, investments can include measures to take account of inflation. This is known as index-linking. The index-linked investment payout – interest on an account or bond, or return on an investment – is linked to a particular index. Such arrangements can apply to a range of common investments, including savings accounts, bonds and pensions.
A common form of index-linking is to ensure investment income increases at the same rate as inflation. A savings certificate, for example, might pay one percent a year plus an extra amount to match the speed at which inflation has gone up. This aims to ensure that the purchasing power of the investment does not deteriorate as prices rise. The eZonomics video How to protect your savings from inflation explains further.
For and against index-linking
Because of the inflation-related payments, index-linked investments typically have a basic rate of interest that is lower than that on an ordinary investment. When choosing between an index-linked account and an ordinary account for which payments are not linked to inflation, investors weigh up how fast they think inflation is likely to rise and how much risk they want to take.
A bond offering five percent interest might look better than a “linker” paying one percent plus inflation. But if inflation rises by more than four percent a year, the index-linked bond will pay more. If the inflation rate slows or turns negative, then linked bonds do worse.
Retirees buying a pension annuity may have an option to index-link the payments so their future income rises with inflation. However, as this tends to mean a lower starting income, it's not an easy decision. A standard annuity will pay a fixed amount, say €5,000 a year, and the purchasing power will decline over time. An index-linked payment might pay €3,000 a year but the amount increases in line with inflation.
A pensioner has to decide whether the index-linked payments will catch up with the alternative. That will depend on how fast inflation rises and how long they live. Likewise, home insurance policies can index-link the value of the goods insured to the rate of inflation.
Your index or mine?
Choosing an index-linked investments will depend on which index the payouts are linked to. Most people understand that inflation is a general rise in prices of goods and services. But inflation can be measured in different ways. While the United States and most European countries use a consumer price index, the United Kingdom also currently uses a retail price index for certain government bonds, pensions and benefits. As well as inflation, investments can be linked to stock market indices to ensure they match average gains in equity prices.
These accounts increase your savings by how much the linked index rises. If the equity index goes down, though, you may lose money. Study the details of any index-linked investments carefully, and the details of the particular index used to calculate returns.