While some reserve professionals place great reliance on the percent funded calulation as an indicator of the "strength" of the reserve fund, we believe that this approach is both too simplistic and based upon assumptions about how the percent funded calculation is made.
Many of these individuals continually state that if you're 70% funded, that is considered a strong level and you generally won't have any problems. The fact is, everyone overlooks the word "generally" and the common misconception is that 70% funded is perfectly acceptable. In some cases it may be, but it overlooks a common problem we see. "Peak expenditure year" is a concept that we developed that provides a far clearer picture of the future. Not all associations have a peak expenditure year, but many do. The concept is that in certain years, multiple high cost components replacement cycles converge, thus creating a "peak" in expenditures. In extreme cases, if the association is anything less than 100% funded, it's looking at a special assessment. We've also seen example of associations that are only 30% funded and are still able to take care of their future expenditures without a special assessment.
What is more disturbing is the fact that, other than our company, no one is disclosing HOW they calculate percent funded. Even many reserve professionals believe that there is only one way to make this calculation, which is to divide the reserve money available (the numerator) by the calculated "100% funded balance" (the denominator). Even assuming the most simple case for calculating the money available (it really should be "net financial resources available"), it is the denominator, the 100% funded amount, that causes the problem, because there are four different methods of making that calculation:
Current cost method
Inflation adjusted cost method
Avergae cost method
Future cost method.
The current cost method, although part of California statutes, is the worst choice of the four, as it is guaranteed to result in underfunding. Using the current cost method, the ideal contribution for each year of the 30-year funding period would be the same, until a new current cost is established. Based on the above assumptions, using the current cost concept means that, if an association were 100% funded and remained that way each year, current association members would NOT be paying assessments based on inflated costs, and the association would end up being underfunded. Current members would not be paying the full cost of the time decay of components, the amount that they have “consumed.” This is not fair to future members, as the underpayment burden is passed on to them.
The average cost method, depending on how it is used, can most closely approximate the inflation adjusted method, which clearly is the only method that can be demonstrated to provide accurate calculations for future years. The biggest problem with using this method is that those few using it also use an average of each given year, meaning the calculation is not tied to the beginning or ending balance, but an average of the tw. That means the percent funded number calculated can't be tied to any financial reports. As such, it is a meaningless number.
The future cost method is also not considered a good choice, as it results in reporting lower than actual percent funded amounts, thereby shifting assessments from future members to current members. This concept correctly applies inflation, but then incorrectly requires that you use the inflated cost for the current period 100% percent funded calculation. Since an exact definition of application of future cost calculations is not made in any state statute, anyone making a future cost percent funded calculation must also make some assumptions. For instance, is future cost the inflated cost at the first replacement cycle? Or is it the inflated cost at the end of the -30year funding study period? Future cost method calculates future total inflated costs and then averages that future cost back to all prior periods, including the start date of the study. This method is used commonly by some reserve preparers.
The inflation adjusted cost method is the only method that can be supported logically, and is the method specified by the International Capital Budgeting Institute as complying with Generally Accepted Reserve Study Standards. This concept assumes that current cost is used for the current period only (first day of the 30-year funding period), and that future replacement costs are inflated annually for purposes of the percent funded calculation. This gives you the same calculation as the current cost method for the current date, and accounts for the effects of inflation so that future costs are properly stated. Current members are always being assessed based on the “then” current cost. This cost concept is fair for all members, both current and future. Inflation adjusted cost method uses current cost for the start date of the study, and the pro-rata future cost based on EACH year of the study, not the total cost at the end of the study. That is the method used by us in our reports, and is the method mandated by ICBI in Generally Accepted Reserve Study Principles.