Legal Definitions - indexing

Indexing refers to two distinct practices, primarily in finance and economics:

• 1. Adjusting Payments for Inflation: This practice involves automatically adjusting wages, benefits, or other financial payments over time to account for changes in the cost of living, typically due to inflation. The goal is to maintain the real value or purchasing power of the payment.

  • Example 1: Government Pension Benefits
    Consider a retired government employee receiving a monthly pension. To ensure their purchasing power isn't eroded by rising prices, the pension plan includes a provision for annual adjustments tied to the Consumer Price Index (CPI). If the CPI indicates a 2.5% increase in the cost of living over a year, the retiree's pension payment will also increase by 2.5%. This is an example of indexing, as the benefit amount is linked to an inflation measure to preserve its real value.

  • Example 2: Long-Term Alimony Payments
    In a divorce settlement, a court might order one party to pay alimony to the other for a period of many years. To ensure the recipient's financial support keeps pace with economic changes, the court order could specify that the alimony payments be indexed to a relevant economic indicator, such as the average wage growth rate. This means that as wages generally increase over time, the alimony payments would also automatically adjust upwards, preventing the payments from losing significant value due to inflation over the long term.

• 2. Investment Strategy: This practice involves constructing an investment portfolio to track or mirror the performance of a specific market index, such as the S&P 500 for stocks or a broad bond market index. The objective is to achieve returns that closely match the index, rather than attempting to outperform it through active stock picking or market timing.

  • Example 1: Retirement Savings in an Index Fund
    A young professional decides to invest their 401(k) contributions into an S&P 500 index fund. Instead of a fund manager actively buying and selling individual stocks based on research, this fund simply buys shares in all 500 companies included in the S&P 500, in the same proportions as their representation in the index. This is an example of indexing, as the fund's strategy is to passively replicate the performance of the S&P 500 index, aiming for similar returns with lower fees.

  • Example 2: University Endowment Fund
    A university's endowment fund, which manages significant assets for long-term growth, allocates a portion of its portfolio to a global bond index fund. Rather than having a team of analysts select specific government or corporate bonds, this fund invests in a diversified basket of bonds that mirrors the composition and weighting of a widely recognized global bond market index. This indexing approach allows the endowment to gain broad exposure to the global bond market at a low cost, expecting to achieve the average return of that market segment.