The following discussion looks at the stability and usability of the Percent Funded analytic tool. At first blush, Fully Funded Balance and its derivative Percent Funded appear remarkably simple and straight forward as useful tools, but a critical look beneath the hood suggests that both may be less than perfect in many regards.
It is a common misconception that the current Percent Funded level determines whether or not the current reserve contribution increases, remains level or decreases. This misconception holds that contributions increase with low Percent Funded levels and remain level or decrease with high Percent Funded levels, but as it turns out, low or high, the current Percent Funded level has absolutely no bearing on the current reserve contribution’s direction at all. The Percent Funded calculation is completely and totally oblivious to the reserve contribution.
Percent Funded only gauges the strength of the fund balance and not the adequacy of the current contribution, so it is entirely possible to have an extremely high Percent Funded level and have inadequate contributions. In this scenario, the reserve fund balance will eventually dwindle and most likely go negative without contribution increases. And the opposite is also possible. A very low Percent Funded level can be overcome by large contributions that don’t need to increase and could possibly even decrease.
What is often overlooked in this discussion is the magnitude of the contribution cash flow versus the reserve fund balance. Over a 30 year span, contributions typically far outweigh any one year’s balance and especially the current balance. Percent Funded places great emphasis on the balance without considering the ever so powerful contribution cash flow.
Percent Funded is a general gauge of risk with lower percentages more risky than higher percentages, and Percent Funded levels have been commonly classified as either poor, fair or strong, but what is lost in this classification is timing. As it turns out, and depending on the timing, being in the strong range (above 70%) may be more risky than being in the poor range (30%) at a different point in time. This is best illustrated with a single component example.
Suppose a roofing component with a million dollar current cost and a 30 year useful life. Now consider this roofing component at 2 different points in time, 1 year before and 1 year after roof replacement. 30% funded 1 year after replacement is no big deal because there are 29 years to make up the difference before the roof gets replaced again, but being 70% or even 90% funded 1 year before replacement is a huge deal because there is only 1 year to make up the difference.
This example illustrates that the classifications are time dependent and what looks good one year may not be so another year.
Click here to view an expanded demonstration of this example.
Percent Funded is the ratio of the reserve fund balance to the Fully Funded Balance. Reserve funds have both beginning and ending balances, but the Fully Funded Balance does not, so which reserve fund balance is used in the calculation?
The national standard provides the following indecisiveness in regards to this question: The ratio, at a particular point of time (typically the beginning of the Fiscal Year) …, but local statutes such as California’s stipulate the ending balance.
There is currently no definitive answer, but does it matter? Probably, the choice of beginning or ending balance does impact the calculation result. Utilizing the beginning balance tends to yield smoother percentages while the ending balance tends to result in greater variations from year to year.
Reality is not always neat and clean, yet components are created to mimic reality, and frequently these realities are over or understated in the Fully Funded Balance. An example of this exists when the identical work has to be entered in two or more components as is often the case when off cycle work is brought back to its regular cycle or when a scope of work changes between replacement cycles. Additional challenges exist for components that have delayed starts, remaining lives greater than thirty years, or are onetime only events. The Fully Funded Balance calculation doesn’t necessarily understand all of these realities and frequently distorts the idealized balance depending on the circumstances.
Let’s consider the example of a onetime only event. What is the useful life of a onetime only event? It may be tempting to say that it is infinite, but what impact does this have on the Fully Funded Balance? Setting the useful life at a maximum value causes the Fully Funded Balance to be immediately and continuously the full replacement cost no matter what the remaining life which is unrealistic if the remaining life is greater than a year. Another approach would be to set the useful life equal to the remaining life. This approach allows the Fully Funded Balance to gradually grow to the full replacement cost over the remaining life period, but here the question frequently arises as to why a onetime event has a short useful life when it has an infinite life (a perceived contradiction).
Just as numbers such as zero can be presented in many ways (0, 1-1, 0*999, ACOS(1), …) so can components, but Percent Funded has a troubling aspect in that it can take different values depending on how components are presented and in fact yield surprisingly different values. Here again this situation is best illustrated with an example.
In this example, suppose an association with a single reserve obligation to replace 30 year lifespan rain gutters on 30 buildings with a current replacement cost of $1,000 per building. In this well seasoned association, only 1 building per year has rain gutters replaced, so basically $1,000 per year is required for rain gutter replacement.
Now consider 2 component approaches, 1 component with a 1 year life versus 30 components each with 30 year life. In the first approach 1 component provides for replacement and in the second approach 30 components provide replacement. Both approaches provide exactly the same rain gutter replacement at $1,000 per year.
The single component approach has a Fully Funded Balance of, you guessed it, $1,000, but the 30 component approach has, and you probably didn’t guess this, $15,500. That is over 15 times the single component approach. Looking at this from a purist perspective, most would probably admit that the 30 component presentation is a more true representation of the actual work (30 different rain gutters replaced on 30 year cycles as opposed to 1 rain gutter replaced every year), but why maintain the mathematically idealized balance of $15,500 when only $1,000 per year is expended?
Click here to view an expanded demonstration of this example.