The Myth of "FULL FUNDING"

The Myth of “Full Funding”

Reserve studies are fascinating tools.  On one hand, a well-executed reserve study can provide great insights and guidance.  On the other hand, a lack of due diligence, documentation and understanding can lead to chaos when angry homeowners rebel against a huge assessment increase and/or special assessment.  

How do you know if your reserve study is accurate AND complete?  Many homeowners and common interest communities do not understand how to use and validate reserve studies, but even more live in fear of full funding.

What is full funding you ask?  For that answer, we look to An Explanation of Reserve Study Standards authored by six different individuals – all of whom are credentialed by CAI – we’ll get to that later…

Full Funding is a reserve funding goal to attain and maintain reserves at or near 100 percent funded…Reserve professionals should consider any association that’s funded within a few percentage points from the 100 percent level to be fully funded.

That’s not self-explanatory.   What is 100% funded?  We now turn to computation methodologies and learn that calculating percent funded is a three step process:

1. Determine each component’s fully funded balance (FFB)

2. Sum the component FFB values

3. Divide the actual or projected reserve fund balance by the sum of #2 for every year of your reserve study

Sounds easy enough!  And it is…if you have a spreadsheet with some built-in smarts like this free reserve study calculator.  Tools like these are exactly what reserve study companies use to crunch the numbers to produce your final product as they turn what started as an organized spreadsheet into endless pages of prose with run-on graphics and charts.

IF it’s really that easy, why do so many reserve studies massively miscalculate your fully funded balance?

Answer: human beings.

1. Components are overlooked

   • • Where is your holistic property component inventory?

     • What’s funded by your annual operating budget vs. your reserve fund?

       1. Are you really going to pay $10,000 or more from your operating budget in some future year to repair or replace a component you’ve excluded from your reserve line-items?

2. Components with useful lives of 40 to 50+ years are excluded

3. Components with “difficult to determine” useful lives are excluded

4. Big ticket components are excluded for the express purpose of improving the “fully funded balance” ratio

5. Components are improperly categorized by failing to break down CE vs. RLCE vs. CLCE, etc. as required by your governing documents

6. Component remaining useful life (RUL) is over or under-stated

7. Components labeled with incorrect costs to maintain, repair or replace

8. Component costs do not include sales tax

9. Unrealistic assumptions re: component inflation and annual interest income

10. Cost and useful life projections are based on actuarial tables instead of actuals for your property in its specific geography and market. 

Many states allow volunteer Boards to have the final say on components, costs, useful life, you name it.  Moreover, state statutes often indemnify both the professionals and the volunteers who create, review and approve reserve studies.  Blanket indemnification creates the perfect environment for commonplace material errors and omissions because nobody can be held legally accountable.

INDEED, unfortunate outcomes still occur even when community associations pay a company often owned and operated by someone with letters after their name – perhaps RS for Reserve Specialist – to prepare a reserve study.  Just like your Board of Directors, reserve study companies are usually indemnified by either 1) your state statutes and/or 2) by the contract you signed when you agreed to pay for their services.  

You hired a professional: an engineer, an RS, or someone with many years of experience to provide this service.  Surely it would be in their best interest to ensure your reserve study is as accurate and complete as possible?  Does the contract you signed provide an incentive that matches that last sentence?  Probably not.  You almost assuredly agreed to pay a fixed price for a service that’s based on brutal efficiency by applying a little bit of human resource time and a lot of rote figures to an algorithm.  

The reserve study business is all about rinse and repeat.  Studies typically exclude thoughtful consulting on a property-by-property basis to produce superlative outcomes because that would be more expensive and viewed as less competitive in an environment where price – not performance – wins engagements.  Regardless of whether the final product is accurate and complete, an incomprehensible mess or simply full of errors and omissions, the company you retained to produce your reserve study is going to get paid and you’re going to repeat this cycle year after year.

LET'S TALK about FULL FUNDING.

Now that you understand WHY your reserve study is probably wrong, let’s focus on the headline.  We’ve already explained full funding,  An Explanation of Reserve Study Standards also defines the following: 

Threshold Funding: establishes a threshold for percent funded or dollar amount funded

Baseline Funding: keeps the reserve balance above zero 

A reserve balance of zero is not healthy.  Zero means that your community has exhausted every penny in an account intended to fund maintenance, repair and replacement for decades and is otherwise known as the point where your community is required to instantiate the dreaded special assessment.  Special assessments collect additional dollars from your owners above and beyond regular assessments funding your annual operating budget.  While a special assessment is often necessary, so too is devoting more money toward future annual reserve contributions.

While your community should absolutely avoid zero, striving to remain “fully funded” (100% funded) is not healthy, either.  This statement isn’t blasphemy: it’s well-accepted math.

First, as we’ve covered, your reserve study is probably full of material errors.  No reasonable organization intentionally funds 100% of an amount they know is incorrect.

Second, let’s assume you’ve addressed all the errors in your study.  Reserve studies are projections, not budgets.  These tools attempt to predict funding needs three plus decades into the future.  Your reserve study projection should necessarily get tweaked ever so slightly every year to reflect a handful of subtle, yet important adjustments and especially to reflect data based on updated actuals and bids.  

Funding a projection at 100% is more expensive than funding at 50%.  Many communities and individual homeowners are keen to identify reasonable ways to reign in costs.  Instead of framing decades of future costs as absolutes, shrewd planners focus on cash flow.  This is the same principle retirement planners use for millions of individuals worldwide with a key exception: your community will continue injecting net new reserve fund principal as part of your annual operating budget.  Unlike retirees, common interest communities typically budget to maintain, repair and replace components ad infinitum.

CASH FLOW is KING.

Your community can safely remain 30%, 50% or 70% funded forever.  HOW?  By creating a consistent funding model that steadily increases your annual reserve contribution in proportion to materially correct figures and conservative assumptions about inflation and interest income.  

Unlike what are often reactionary annual operating budget increases, your annual reserve contributions should increase by a fixed percentage (3%, 4%, 5%, etc.) to meet the projections of your reserve study over the course of decades.  If your reserve study is materially correct, your scheduled reserve contribution increases should remain within 0.25% in any 2-3 year period and your future contributions should look relatively hyperbolic.  Just like your operating budget: current owners pay less and future owners pay more.  Unlike your operating budget, reserve contribution increases are planned over decades to account for the big picture.