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If you are from Alberta, then there’s a good chance you’ve heard the term ‘indexing’ mentioned more than once amongst all the chatter about the provincial budget. I’m not going to talk specifically about the budget. There are significant cuts, many in areas I don’t believe deserved them, and overall I’m struggling to see the upside. That is all I’ll say. Instead, I want to talk about indexing because it’s an important concept to understand in way more aspects than just this budget.

What is Indexing?

According to Investopedia, indexing is an indicator or measure of something. Awesome. We’re all super clear and I can stop writing now right?

The problem with defining indexing is that it has a few different meanings in the financial world. You can be an index investor, have an indexing clause on your pension, tax brackets can be indexed for inflation, etc.

Index Investing

Index investing is a passive investment strategy where you buy a fund (mutual fund or ETF) that holds a piece of each company listed on a specific index. For example, the S&P/TSX Composite index is the most well-known stock market index in Canada. You can buy a fund that would hold stock of all the companies listed on that index. Instead of making guesses on which companies will do well, you’re just putting your money on all of them. It’s a good strategy if you want a fairly hands-off portfolio.

Sound interesting? Let me turn you over to the pros at Canadian Couch Potato. They’ll be able to talk you through index investing far better than I can.

Indexing for Inflation

Inflation is a much easier term to define. It is the increase in prices over time. We all feel this. A loaf of bread and carton of milk cost more today than they did twenty years ago. And don’t even get me started on house prices!

To figure out the actual inflation rate, we use the Consumer Price Index. Oh look, another index! The CPI is a hypothetical basket of goods and services a typical family would purchase in a year and the cost of that basket is calculated annually. The amount it increases determines the inflation rate for the year. The Bank of Canada works to keep the inflation rate between 1% and 3% annually.

The problem with inflation is that if your income isn’t growing at the same rate as your expenses, then you are actually losing money. Some companies will offer a cost of living adjustment to ensure your salary keeps up with inflation. Either way, you should be pushing for an annual raise, but it’s even more important if your employer doesn’t have a COLA policy.

Tax Bracket Indexing

The change that triggered this post. One of the new policies implemented by the Alberta government to save money is pausing the indexing of tax brackets. While they might say they aren’t raising taxes, you’re still going to end up paying more.

Here are the current tax rates in Alberta:

2019 Tax Brackets (Alberta)

IncomeTax Rate on Income
$0 - $12,0690.00%
$12,070 - $19,36915.00%
$19,370 - $47,63025.00%
$47,631 - $95,25930.50%
$95,260 - $131,20036.00%
$131,201 - $147,66738.00%
$147,668 - $157,46441.00%
$157,465 - $209,95242.00%
$209,953 - $210,37143.00%
$210,372 - $314,92847.00%
$314,929 +48.00%

You see how all the brackets have weird numbers? That’s because they increase with inflation every year. Well, they did. Now those brackets are going to stay the same indefinitely. In Alberta we have a basic personal amount, and no one pays tax on their income up to that amount. Usually it goes up a few hundred dollars a year, but now it will stay the same. That’s a few hundred dollars that each of us will now be paying tax on. The effect multiplies as your income increases through the tax brackets. So yes, tax rates might not be going up, but you will be paying more in taxes. Wordplay is fun.

Pension Indexing

Most Canadians will receive CPP (Canada Pension Plan) and OAS (Old Age Security) benefits when they retire. Both plans are indexed, so your payments will go up with inflation. This is helpful for retirees who are living on a fixed income and don’t have the ability to earn more.

If you have a pension through work, it may be indexed. This would only apply to defined benefit plans. Those are the ones that will pay you a set amount each month of retirement, and it’s guaranteed for life. Defined contribution plans are different in that they only payout the amount you’ve put in plus any growth.

How to Index Your Own Savings

Many of us don’t have an employer offered pension plan, so we are on our own when it comes to retirement savings. That doesn’t mean you’re free from worrying about inflation. You need your assets to grow and cover your future retirement needs. To make that happen, there are two things you should be doing to protect yourself from inflation.

Your Savings Rate

Most of us think about saving as a dollar per month amount. When setting up an automated contribution, we have to put in a dollar value not a percent. The problem? How many of us think to change that dollar value when we get a raise?

Instead, it can be helpful to calculate your savings rate. Divide the amount you save each month by your income (I prefer using net income, but it doesn’t matter), and you’ll get your savings rate. I recommend saving at least 20% of your income. If you can do more, even better! If you get a raise or increase your income another way (maybe a side hustle), then you should increase your savings amount by the same percentage. The goal should be to keep your savings rate the same. That’s using indexing for your own savings!

Investment Returns

Increasing your savings rate is excellent, but you also need to make sure those savings are earning you money. As we discussed, inflation in Canada is usually between 1% and 3%. If your money isn’t earning more than inflation, you are losing purchasing power. Not great. Especially when it comes to retirement savings that will be losing out for years and years.

Not all your money needs to beat inflation, but when we look at longer-term returns the bulk of it should be. If you keep a significant balance in your checking account, it will be earning you nothing. Even moving that to a high-interest savings accounts earning 2+ percent will help limit inflation risk. That’s a great option for money you may need in the short-term like your emergency fund, vacation money, etc. For long-term investing (like retirement), you can take more risk and get that money into the market. You might think that not investing is the safest option, but you’re just taking on a different kind of risk.

Indexing is an important concept in personal finance because it works both ways. It can help grow your money but can also eat away at it as inflation increases your expenses. By understanding how it works you can take steps to negate the bad and amplify the good.

Heard of indexing? Find out how it impacts how much you earn, spend, and save!

This post was proofread by Grammarly

Image Credit: Thomas Kelley

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