Boards and managers who want to ensure adequate funds and avoid shortfalls (or at least get into a better financial position) should familiarize themselves with common reserve funding goals and the strategies to achieve them. As outlined in the National Reserve Study Standards (NRSS), four accepted funding goals are available to community associations. Each goal involves a strategy to identify the reserve contribution rate for residents each year while maintaining a predetermined reserve fund balance. Each of the four funding strategies are generally determined by analyzing the risk tolerance and best interests of the community. When you engage a professional reserve study provider, they will suggest the strategy that is most applicable for your specific community. Let’s briefly review each funding goal.
The first funding goal is Full Funding. This is a goal of attaining and maintaining a 100% funded reserve balance. In order to have a 100% fully funded balance, an association would need to have the equivalent of the sum of the fully funded balances for each individual component in their schedule. The fully-funded balance for a component is the replacement cost relative to the portion of life that is “used up.” For example, if an item has a $100,000 cost and is halfway through its useful life, the fully funded balance would be $50,000. The fully-funded balance for each item is added together to determine the fully funded balance of the overall fund. Full funding is the most conservative funding goal. In practice, there is typically no justification for why an association would need to have 100% of the fully funded balance on hand at one time. For most communities, where projects are dispersed over many years, this goal results in mass amounts of money being held aside unnecessarily. However, in communities where all component repairs and replacements come due at the same time, this goal may be unavoidable, though this situation is extremely rare.
The second funding goal is Threshold Funding. The most commonly recommended strategy, the goal is to keep the reserve balance above a minimum amount at all times. Setting this goal requires looking at the cash inflows and outflows to the reserves over time. Since most communities never replace everything at one time, the balance is allowed to increase and decrease as time passes. The inflows can be set at an adequate and stable level that ensures the reserve balance never drops below the threshold, even in critical funding years when the balance is at its lowest. This goal is ideal for most communities as it involves stable funding, equitable contributions across time, and adequate funds for major repairs and replacements, which happen throughout the life of a community, but usually not all at once.
Next up is Baseline Funding. This goal operates similarly to threshold funding, however, the reserve fund hits a $0 balance at some point over the length of the reserve study. This is a riskier strategy than both full funding and threshold funding. It is generally only acceptable in situations of distress as there is no cushion whatsoever on the cash flow. If any capital project comes early or costs more than expected, this strategy could put the association in a funding deficit. This goal is not ideal but is better than deferring critical life safety issues or other expenses that will result in higher costs if ignored, such as roofing.
Last is Statutory Funding. Because statutory funding refers to the amount of money required in reserve funds to comply with state statutes, this funding goal is non-negotiable. The logistics of such funding vary by state and are often not specific to a particular association’s needs. For example, Michigan requires associations to maintain a reserve fund of 10% of the annual budget at a minimum, which occurs on a noncumulative basis. Furthermore, Michigan associations’ bylaws are legally obligated to contain specific verbiage regarding the minimum standard. Overall, this strategy simply requires associations to follow specific state funding laws. Many state laws allow for any of the other three goals so this is not applicable in those states.
The great benefit of multiple funding options is that there is almost always a viable plan for associations to follow to attain and maintain adequate reserves. Whether an association is severely underfunded or in a solid financial position, there is a path forward. When you commission Reserve Advisors, your consultant will work with you to understand your goals and determine the best possible funding strategy to utilize going forward. Our extensive experience in financial analysis and planning means that no matter your current situation, our recommendations are the beginning of a successful future.
Do you have questions regarding reserve funding strategies and reserve studies in general? Don’t hesitate to reach out!
