Most reserve fund accounts earn investment interest that is reinvested into the reserve fund, so reserve fund interest earnings are an integral element of the reserve funding plan. Estimated reserve fund interest earnings are calculated taking into account interest rate, tax rate, inflation rate and cash flow assumptions.
Reserve fund Interest is typically reinvested into the reserve fund and therefore factored into the reserve funding plan. Since the interest rate assumption is applied at a constant level over the entire funding plan span, the Interest rate assumption is based on a conservative long term average rate and not on current short term levels. The maximum interest rate assumption may be regulated within local statute, and best practices limit the maximum interest rate assumption to no greater than 2% above the inflation rate assumption.
The effective interest rate may need to account for possible tax liabilities. Depending on client preference, interest earned tax may be paid from either operating or reserves, and when interest tax is from reserves, the assumed interest rate is reduced by an appropriate tax rate.
Since inflation impacts reserve expenditures, a single inflation rate assumption is applied universally to all components for all years, and just as the case with the interest rate assumption, the inflation rate assumption is based on a conservative long term average rate and not on current short term levels.
Beyond interest, tax and inflation rate assumptions, an assumption is also employed to accommodate the uneven annual reserve fund cash flow. While transfers into the reserve fund tend to occur steadily throughout the year, reserve expenditures are sporadic. Accommodation for the sporadic cash flow is accomplished by assuming that one half of all transfers into and expenditures out of the fund occur at the midpoint within the year, so the balance against which the interest is calculated is the midyear balance where it is assumed that half of the income has been transferred into reserves and half of the expenditures have been paid out of reserves.
Reserve Fund Interest Formula
Interest Earned = Interest Rate * ( 1 – Tax Rate ) * ( Beginning Balance + ( 0.5 * ( Reserve Contributions – Reserve Expenditures ) ) )
Reserve Fund Interest Calculation Example
Interest Rate = 2.5%
Tax Rate = 30%
Beginning Balance = $100,000
Reserve Contribution = $25,000
Reserve Expenditures = $20,000
Interest Earned = 0.025 * ( 1 – 0.3 ) * ( $100,000 + ( 0.5 * ( $25,000 – $20,000 ) ) ) = $1,793.75
The same “half at midyear” assumption applies to any other reserve funding inflow or outflow including excess funds transfers, special assessments, loan proceeds, loan repayments, reimbursements, etc.