Pros and Cons of Different Types of Reserve Study Funding Plans

This paper explores the advantages and disadvantages of different types of funding plans, and it is the second half of a two-part article. For additional background information, please see the first article: Reserve Study Best Practices & the Most Common Omission in Forecasting.

Many reserve study consultants recommend a fully funded plan, but there are other types of funding plans that might be more beneficial based on your situation. Our article explores the advantages and disadvantages of five options: 1) Fully Funded Plan, 2) Baseline Funding Plan, 3) Threshold Funding Plan, 4) Statutory Funding Plan and 5) Modified Funding Plan.

Funding Plan Types:

The NRSS, CAI, RPDC, and APRA utilize the Component and Cash Flow methods for the four (4) funding plans they recognize and endorse.  HUD utilizes the Component Method / Fully Funded Plan. We have added a 5th option, a Modified Funding Plan.

  1. Fully Funded Plan: This 100% funded plan utilizes the Component Method, funding the accumulated depreciation of each component and account, and making up shortfalls by special assessment or utilizing the Catch-Up Period funding method.
  2. Baseline Funding Plan: This plan utilizes the Cash Flow Funding Method, determined by setting minimum funding levels to fund expenses so the reserve balance never drops below zero dollars in the worst year(s) during a specified term of years, typically 20 years.
  3. Threshold Funding Plan: This is the Baseline Funding Plan but with a specified minimum contingency threshold amount (reserve balance) in the worst year.  The reserve fund balance in the worst year is the threshold amount adjusted for inflation versus a worst year base line zero reserve balance.
  4. Statutory Funding Plan: This is a mandated plan based on a statute (mandate), which is a covenant, or a local or government statute.  The statute may simply require compliance with any one of the nationally recognized funding plans detailed above, or it may specify other unique requirements.
  5. Modified Funding Plan: When standard NRSS funding plans do not meet the need, a Modified Funding Plan may be tailored.  Oftentimes, clients discover they are significantly underfunded and cannot tolerate the significant first year special assessment or required initial increase.  Instead, they modify their funding plan with incremental increases until they are caught up.  This is most typically a modification to a Cash Flow Funding Method.  In some cases, a client will elect a Component Method (Fully Funded Plan). However, instead of funding 100% of depreciation, they elect a lower funding level, i.e. 60 or 70% depreciation.  This is fine assuming no shortfall occurs in any given year; this minimizes the issue of tying up excessive cash in funding reserves.  This is popular when Statutory Funding Plans mandate the Component Funding Method, but do not specifically state that depreciation must be funded 100%.

There are benefits to each funding plan and each is subject to funding shortfalls as further explained in the below Summation; be aware of and account for this risk.  Risk factors to consider are errors and omissions, quality of management and maintenance, premature failure, faulty workmanship, obsolescence, or factors beyond anyone’s control such as vandalism, theft, weather, acts of God, and others.

Summation:

The trend for reserve-study consultants is to recommend the Fully Funded Plan, with a contingency allowance budget to mitigate the risk of a shortfall, error, or omission.  The Fully Funded Plan, assuming reasonable consideration has been given for contingencies, is the least likely to experience an underfunded event or shortfall.  The fundamental reason for this is there are funds available for each item plus a contingency for variables such as a premature failure, or omissions.  Therefore, the primary risks are a function of identifying all budget items and then assigning an accurate replacement schedule and pricing.  Risk is offset by the contingency and possible savings in other accounts. This funding plan is believed to minimize, or even mitigate, the risk not only to managers and boards, but also to the consultant, as to possible lawsuits due to negligence or errors and omissions.  However, the Fully Funded Plan requires the highest level of funding, and can unnecessarily tie-up valuable cash assets.

The Cash Flow Method is most popular since funding levels typically are significantly less than the Component Method (Fully Funded). However, it is important to understand that when utilizing this method, funding is based solely on the amortization of the replacement expenses for only those items to be replaced during the specified budget term; there are no reserves for items scheduled for replacement beyond the specified term.  Should an item beyond the funding term need replacement during the term, its replacement expense has not been included in the amortization.

Another peculiarity of the Cash Flow Method is that a “worst year” occurrence, on which the funding level is based, will in most all cases occur in a year other than the last year of the specified term.  For the years following the worst year, the funding level resets to a lower funding level based on amortization of the remaining expenses over the remaining balance of years of the specified term.  This lower funding level will cause a problem if major upcoming expenses do not fall within the remaining term.  Therefore, the lower funding level should be re-evaluated by looking beyond the specified term, if the number is to be used for funding purposes.  Just how many years beyond the specified budget term should be evaluated becomes a judgment call; look out far enough to include all major items that occur over the next several years.  If funding levels change significantly, then the budget term should be adjusted to include these major items.  Work with the consultant to determine the best number of years to specify as the budget term and to determine the validity of the second funding level.

To manage risks associated with the Cash Flow Method, there are three fundamental practices to employ: (i) as a minimum, set the funding levels based on no less than 20 years; (ii) adhere to NRSS recommendations for Level 1 and Level 2 updates; and (iii) look beyond the specified budget term for the occurrence of all other major expenses and their effect on funding levels.  Adherence to these practices should adequately manage the risk associated with an unexpected or unfunded expense, not tie-up valuable cash assets, and provide consistent funding levels adjusted annually for inflation.

When working with your consultant, make your own decision on the funding plan that is best for your situation.  Base this decision on factors pertinent to your business model by taking into account the previously discussed risk factors and funding plan concepts.  Consider the needs and capabilities to fund potential special assessments.  These practices coupled with proper management should provide the best funding plan and results.

Funding plans should not be a static one-time report, but should be a dynamic process.  NRSS recommends first a Level 1 study; the inspection and budget study are completed by a consultant and subsequent years annual updates by the owner.  Additionally, NRSS recommends a Level 2 update every three years; the funding plan is reviewed by the consultant based on a site inspection.  A Level 3 is an update by the consultant, without a site inspection.  Every situation is unique; therefore, depending on various factors, updates may or may not justify a site inspection.

Below is a list of questions to help clarify when an update merits a Level 2 consultant update and site inspection:

  • Has any significant maintenance been deferred?
  • Did annual funding contributions occur as planned?
  • Did all significant expenses occur as planned?
  • Has the reserve balance deviated more than 5% from the desired percent-funded goal?
  • Has local pricing or inflation been significantly impacted?
  • Has a significant building code citation been received?
  • Have there been any new mandated changes of significance made to the building codes?
  • Have any major systems or equipment become obsolete?
  • Has there been any extreme wear or tear to major components or critical systems?
  • Have any major systems or components been added, overhauled, or replaced?
  • Are any developer, contractor, or critical manufacturer warranties set to expire?
  • Are there new technologies or product developments that may impact operations?
  • Have any environmental/geological events occurred that may have a negative impact?
  • Has there been any significant change in demographics or competition?
  • Has there been a change in service vendors, property managers, or senior level executives?
  • Has there been a change in the leadership or membership of the board or trustees?
  • Is there a plan to refinance, apply for accreditation, renovate, expand, sell, or merge?
  • Is there any significant change to corporate goals or mission?
  • Has it been three years since the assessment and funding plan was completed (note: NRSS recommends every three years)?

“Risk management” factors into literally every business decision, whether your business plan is margin or mission driven.  Funding replacement-reserves minimizes maintenance risk, one of the principal risks in property ownership.  Choosing to manage maintenance risk by funding reserves is a fundamental and sound business practice that will help preserve margins and ensure your mission and long-term goals are achieved!

Sample Funding Plan Reports:

The following are sample sets of reports produced by FacilityForecast® Software, demonstrating various reports and funding plans. A review of these reports and plans will assist in understanding the various NRSS funding plans and benefits, so you can identify the funding plan that best meets your business model.

FUNDING SUMMARY REPORT

This report summarizes the required report parameters and the first-year results for the various NRSS funding plans and, too, includes a modified plan.  Review this first and note the various monthly contributions.

Below are sample table and chart report sets for each NRSS funding plan based on 3% inflation, 1.5% interest earnings, and 95% occupancy. Please note for CIRA-type properties, such as condominiums, time-shares, and cooperatives, use 100% occupancy since every unit has an owner.

CURRENT FUNDING PLAN REPORTS

is is an analysis of the owners’ Current Funding Plan.  In best case, the current plan is designed to meet a business model and complies with a NRSS funding plan.  Worst case, it is nothing more than a “pay-as-you-go” special assessment plan. The Current Funding Plan report answers the fundamental question “does the current plan meet funding needs, are we over or under-funded?”  In this example, under-funding is first experienced in year 2023 with a shortfall of $417,398, which only worsens each year.

FULLY FUNDED PLAN REPORTS

This example complies as a Fully Funded Plan per NRSS, even though the plan is slightly below 100% funded during the term of this chart.  It complies since the shortfall is funded by the “Catch-Up” funding method. This method allows funding depreciation based on “remaining life” of underfunded items, until each is fully funded versus funding depreciation based on the “full life” plus a special assessment to make up the shortfall.  Note the Percent Funded ramps up each year reaching 99.92% by year 2037.  Should we run the calculations out to 100% funded, it takes the Catch-Up method until year 2068 to reach 100%.  The Catch-Up method is usually preferred over the option to fund a shortfall with a one-time special assessment, which, in this case, this is a $350,000 shortfall.  This owner found either option far too expensive; the increase from the Current Funding Plan of $1,076,891 to $2,382,396 in the first year was simply not affordable. Few, if any, organizations would find this plan tolerable. Also note that this plan realizes a reserve balance in 2037 totaling $13,905,370, tying up valuable cash resources never to be needed; evidenced by the funding plans described next.

BASELINE FUNDING PLAN REPORTS

The two fundamental benefits of this plan are to minimize annual contribution levels and to avoid tying up valuable cash assets unnecessarily.    This is a much more affordable plan with annual contributions starting at $1,298,270 versus $2,382,396 for a Fully Funded Plan.  Also note the maximum reserve level totals $5,278,749 versus the Fully Funded Plan at $13,905,370, both occurring in year 2037.  This meets the goal of minimizing cash reserves. However, in year 2031, the reserve balance drops to zero dollars, which can prove risky.  This risk can be minimized by conducting recommended NRSS Level 1 and 2 updates, or using a Threshold Funding Plan.  Note the first-year funding level of $1,076,891 is an increase of 21% to $1,298,270, which for some may not be tolerable and, therefore, requires some adjustments.

THRESHOLD FUNDING PLAN REPORTS

This is essentially a Baseline Funding Plan with a contingency.  The contingency in any given year is the “threshold” amount adjusted for inflation.  The threshold amount is calculated by taking 2% of the total one-time replacement cost of $14,953,034 adjusted for inflation; as noted in the above Funding Plan Summary Report. The 2% is a subjective amount depending on the owner’s tolerance for risk and other factors, such as the condition of the property. For this plan, the year 2031 has the lowest reserve balance of $443,957 (when considering adjustments for inflation), which is all contingency.  Note, based on the original funding level of $1,076,891, this is an increase of 23% to $1,320,599 in the first year, which for some may not be tolerable and, therefore, requires some adjustments in the first few years.

MODIFIED FUNDING PLAN REPORTS

When standard NRSS funding plans do not meet the need, a Modified Funded Plan should be tailored.  This owner could not tolerate a $350,000 special assessment or the required initial increases, which vary depending on the plan.  In this example, the Threshold Funding Plan required $1,320,599 in the first year, a 23% increase in the first year over the Current Plan of $1,076,891.  Instead, the owner elected to increase the first year by 8% (from $1,076,891 to $1,163,042), with incremental compounded adjustments of approximately 8% for 3 more years, and 6.38% in year 5 at which time funding is caught then requiring 5% annual increases.  The “Modified Funding Plan” model proves invaluable since an owner can vary increases to coincide with tolerance.

About the Author:

John H. zumBrunnen is the CEO and founder of zumBrunnen, Inc., an independent building consulting firm based in Atlanta, Georgia.  The recipient of a BS in mechanical engineering from the University of North Dakota and a member of LeadingAge, zumBrunnen has 45-plus years’ experience in construction, facility assessment, and capital replacement planning.  He is the developer of the FacilityForecast® Software system and a respected speaker in the industry.

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