And thank you for reading the kick-off blog post of our 2014 educational series!
At PFCS, our mission is to empower our community with actionable information – and the programming we’ve put together for this year’s educational series is designed to do just that. So be sure to stay tuned for future blog posts and webinars!
I’ve decided to kick off our thought leadership efforts with a deep-dive into reserve funding and contingencies! (hold the eye roll, please)
Building owners and associations absolutely need to put money aside for future expenditures and repairs. But the fact is, funding a 100% contingency is a conservative approach and, in many cases, can be wasteful. With the right approach you can hone in on your future costs, mitigate risks, and strike a reasonable contingency balance.
Skeptical? Don’t worry, I’ve called in the cavalry. Who better to explain the nuances (and best practices) of reserve funding and risk mitigation than David T. Schwindt?
David is the owner of Schwindt & Co and provides accounting, tax and reserve study services to over 500 Associations in the Pacific Northwest. His expertise and insights are invaluable to building owners and associations struggling to understand reserve funding and risk mitigation – so listen up!
Part I of this four-part series will cover reserve studies and funding models – what they are, how they’re developed, and what it means for your finances. In Part II, David will dive further into reducing the risk of ‘surprises,’ special assessments, and the need to overfund your contingency.
Feel free to post your questions in the comments section below, and be sure to check back for Part II. Thanks for reading!
Reserve Funding and the Risk Mitigation Matrix
By David T. Schwindt, CPA RS PRA, Guest Blogger
What are Reserve Studies?
Reserve studies involve two distinct phases – the physical analysis and the funding analysis.
- The physical analysis includes, but is not limited to, determining the association’s legal responsibility of repairing, replacing and maintaining association property (components) and identifying components and their condition, cost and useful life.
- The funding analysis includes preparing a funding model that considers the cost and frequency of repairs/replacements/maintenance procedures. This funding model generally includes provisions for inflation on future expenditures, interest earned on reserves and income taxes.
The theory behind funding is simple: determine how much money the association should set aside in the replacement reserve bank account each year so there is always enough money to pay for needed repair, replacement and maintenance expenses - and assess accordingly.
Since this funding model is based on numerous assumptions, many association professionals prefer to include a contingency amount in the funding model.
Although the theory of funding is relatively simple, the calculation of the required contribution to reserves is complicated by the various methods of funding and the determination of the appropriate contingency. For purposes of this article, contingency is defined as “the amount of cash set aside in the replacement reserve over and above the calculated amount needed to fund 100% of needed expenditures.” In other words, it is extra cash to fund unbudgeted expenditures or “surprises.”
Three Types of Funding Models
Community Association Institute (CAI) Reserve Specialist and Association of Professional Reserve Analyst standards include three acceptable funding models – baseline, threshold and the fully-funded model. (Note that there are other terms that describe these models; for sake of simplicity I am using the above terms).
Each of these models calls for a different level of contingency funding, which relates directly to their ability to mitigate risk. Figure 1 illustrates the level of contingency built into each model:
Baseline Funding Models
The baseline method includes a funding model that funds all expected costs over a specified period, in many cases thirty years. Although this model funds the replacement reserve bank account for all expected costs, it does not include a contingency amount should any components cost more than expected.
Proponents of this method only want to fund expected costs to maintain, repair and replace common area components. Note that this model is the bare minimum of funding and assumes there will be no surprises.
Over a thirty year period, the baseline funding model would show a cash flow projection that funds all expenditures and at some point the cash balance in the replacement fund bank account would drop close to a zero balance and then start building cash for the next major expenditure. The year the cash balance drops close to zero is risky to the association since there is no extra cash to pay for surprises.
Threshold Funding Models
The threshold method includes a funding model which funds all expected costs (much like the baseline method) but also includes a contingency amount for surprises. Reserve study specialists refer to this contingency as the “threshold.”
The threshold method would provide an amount that the projected replacement reserve cash balance would not fall below, say $100,000. This $100,000 is called the threshold and provides needed funds to pay for surprises. Proponents of this method realize that over a thirty year period, unexpected costs may arise and it may be prudent to have extra cash to pay for these surprises. The challenge for reserve study providers is determining the amount of the threshold or extra cash.
The fully-funded method uses a formula for computing the threshold that mirrors the method used for computing depreciation.
The fully-funded formula computes a threshold that, in some cases, allows funding for twice the amount of expected costs. Knowing that the fully-funded method, if 100% funded, provides for a very large threshold, reserve study providers often use a funding target of less than 100%.
Please note that the higher the percent funded, the more extra cash is kept in the replacement reserve bank account as a contingency, over and above the amount necessary to pay for all expected repairs and replacements.
Proponents of this method realize associations have ‘surprises’ and it is prudent to have as much cash as you can as a contingency to provide for these costs.
Best Practices for Overfunding
These three funding models (baseline, threshold, and fully-funded) cover the spectrum of contingency funding that any association should consider for their reserve account. However, none of them offer a single, prescriptive best practice for reserve funding.
Figure 2 summarizes the takeaway of the next post in this series – which covers reserve study best practices for mitigating risk and reducing the need to overfund your contingency.
As you can see from the matrix, proactive steps, including adequate and accurate physical analysis, can be taken to reduce the need for an overfunded contingency while simultaneously preventing unexpected surprises and maximizing the ROI of your building investment.
Be sure to check back for Part II, where David will dive into these best practices for reducing the risk of ‘surprises,’ special assessments, and the need to overfund your contingency.
To read David’s profile and learn more about Schwindt & Co, visit www.schwindtco.com.
The Reserve Funding Series
- Part I: Getting a Grip on Reserve Funding Jan 8, 2014
- Part II: Best Practices in Reserve Funding & Risk Mitigation Jan 27, 2014
- Reserve Funding & Risk Mitigation: The Bottom Line Feb 13, 2014