(And How Can You Tell)
By: Roy Helsing
There is a critical step often missed by Boards of Directors in determining their association’s reserve assessment for the next budget. That is establishing a true understanding of how much is enough. Worded differently, it is how much risk is the association going to take, and when that risk will manifest itself. Sure, you paid for a reserve study (good for you). Hopefully you had it done by a Professional Reserve Analyst (PRA)*, and if not, by a Reserve Specialist (RS)* so that at least you have some confidence that they are following national standards, and the math is something that can be defended.
However, even when prepared by qualified persons, reserve studies may differ substantially. They typically include at least a single funding recommendation, and some include a choice of funding recommendations. In either case, the critical (often missed) step takes place right here. Is the Board going to follow it? Does the Board understand why that recommendation was given? Or if given choices, what recommendation do they want to choose? Are there more possible choices?
In fact, there are many funding options the Board could accept. The problem is that all the numbers confuse many, and therefore many Board members (and managers) never look further to try to understand the concepts. This article stays away from math – and makes conceptualizing simple, visual, and step-by-step.
The Fully Funded Balance (FFB) is a number that represents how much money should be in the fund given the portfolio of components (including lives and costs) in the component list at the time of this study. It is basically the amount of money that should be in the reserve if everyone in the past had paid their fair share of the wear-out to date. Simply put, if you had a $100,000 component with a 10-year life, the association would be putting in $10,000 per year, and if the component was three years old there would be $30,000 in the fund. If you added this up for the current year for all the components the result would be the Fully Funded Balance (FFB) at the present time. (All you purists out there don’t go buggy about the time value of money and other issues – we are keeping it simple here and this is my one and only transgression into using math in this article). This FFB can be calculated out into the future year by year for however long is desired, but 30 years is typical. In a graph, it would look like this:
There are two important things to remember about the Fully Funded Balance (FFB) going into the future. First, every portfolio of components will create a unique graph. Secondly, there will always be a “low” year and it will be a different year for each association.
Where are you currently and where are you headed? Don’t panic if your association is not “Fully Funded” (or in some states “100% funded”). The probability at any point in time of being exactly Fully Funded is very, very low. Arguments can be made that full funding is overfunding. Arguments are also often made (usually by the uninformed) that anything less than full funding is “underfunding”. The real issue is a combination of where are you, and where are you going. More importantly, why are you going there? (A wise man once said “If you don’t know where you are going, any road will get you there.”) On the other hand, how will you know if you have arrived? That is exactly what the Boards should be considering when they review their reserve funding plan. That is the missing step we are talking about. So, to understand that you need to understand three other basic concepts – Full Funding, Baseline Funding, and Threshold Funding.
A Fully Funded Funding Plan does not mean you are at the Fully Funded Balance (FFB). It means you have a plan to get your reserve fund from where it is to the FFB line at some point in the future. Below is one example:
In this example, the blue line represents a funding plan that reaches the FFB at thirty years. The Board of Directors could have decided they wanted a plan that got them to the FFB in any number of years – from one to thirty. Obviously, the quicker they want to get there the higher the necessary reserve assessment. Conversely, they may decide they never want to get to the FFB. Whether they do or not is not important. What is important is managing risk in the “low year”. In this scenario the low year is the 19th year. The association expects to spend $1,000,000 in the 18th year, leaving a balance of $254,000 in the fund at the end of a heavy construction year. After that, they have no major expenditures for a while so the question the Board should be asking themselves is “If we do a million dollar construction job, is $250,000 in the bank at the end enough to cover us for cost overruns and unknowns?” If the answer is yes, this is a reasonable funding plan. If it is not reasonable, then they may want to increase their assessments along the way so that they reach full funding earlier, but more importantly so that they have enough money in the bank after the major construction to feel comfortable they can handle the unknowns. For this hypothetical association to reach this plan it requires an assessment of $76 per unit per month (PUPM) adjusted for annual inflation at the current rate. (This is only relevant to make a point later, don’t get too hung up on that now.)
A Baseline Funding Plan means that the association never intends to run out of money. Using the same hypothetical association shown above, with the same expenditures, and reducing the assessment to $71 a unit per month, the funding plan would look like this:
In this plan the association saves $5 per door per month, but the risk is that the association may have cost overruns after the $1,000,000 project in the 18th year. Any overruns would cause construction to stop while the Board went out for a special assessment. Not many people would call this a reasonable risk, yet there are still a few reserve analysts in the nation calling this “Full Funding” under the mistaken belief that if the association will theoretically never run out of money, that is all the money it will need. Don’t be fooled. Reserve calculations are still based on potentially imperfect assumptions of life, cost, inflation and interest. No reasonable person would assume the plan above is a reasonable assumption of risk.
Then there is the Threshold Funding Plan where the board designates some threshold of funding they do not want to fall below. That threshold can be designated in a variety of ways. For example, “We do not want our fund to ever get below $300,000” or “We always want to have a threshold of at least 10% of that year’s expenditures.” The threshold is nothing more than the Board designating some safe level that they want to keep the fund above. Below is a threshold funding plan at $75 per unit per month on our hypothetical association:
Again, the emphasis should not be on what the plan is called, but on the risk the Board wants to take. This threshold funding plan is not much different than the full funding plan present in our first scenario. Homeowners pay $2 a door per month less, and after a $1,000,000 construction job, the association is planning on having about $200,000 on hand rather than $254,000. These are Board decisions. The teaching point is that too often Boards are not making these decisions. Instead, many are automatically going with the recommendation of the reserve study preparer, which may or may not reflect the Board’s risk tolerance and long-term strategy. For our hypothetical association, any one of the above scenarios could be presented as a proper recommendation. The Board really does need to understand what assessment they are adopting.
Now, let’s get a bit more advanced. Below we have a totally different association – a different portfolio mix. This time we are presenting a full funding plan to reach full funding in the 19th year which happens to be the “low year’.
Two points here. First, even though this association will be fully funded in the year they need (in this case) almost $1,500,000, they will have very little left in the bank at the end of construction. The Board needs to decide if this is a reasonable risk. The second point, however, is important to understanding the concepts. There is a sort of common sense belief that a full funding plan has greater reserve balances than a threshold funding plan. That is not necessarily true. With certain portfolio mixes, full funding in some years may have dangerously low balances. If you think about it, if all the components came due in one year – the association could have no money in the bank and be fully funded! Associations whose components are few in number but high in dollar value are most likely to fit into this scenario.
One final point: These funding concepts are not mutually exclusive. The graph below represents a funding plan that reaches Threshold Funding in the 19th year and Full Funding in the 29th year:
While it is good to understand each of the funding plan concepts, it is more important to understand they are not absolutes. It is critical that Boards understand the following:
- Do not approve a funding plan without understanding it.
- Understanding it means doing an analysis of risk in the “low” and therefore “critical” year.
- Those that want to say “full funding” is safer than “threshold funding” should be ignored – they simply don’t know what they are talking about. Each association’s portfolio and requirements need to be analyzed individually to reach a level of risk the board is comfortable assuming.
*PRA is a designation granted by the Association of professional Reserve Analysts (APRA)
*RS is a designation of Community Association’s Institute.
The Helsing Group, Inc.
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